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Retirement Weekly: Should I invest in an IPO?

Q.: I’ve read a number of stories about how IPOs have shot up giving quick high returns. I’m wondering if I should be investing in IPOs. What do you think about doing that?

–Tom in Naples

A.: Tom, my first thought is if you are thinking that you’ll make a quick buck buying shares of a company the first day of trading, you are more likely speculating than investing. It is true some initial public offerings (IPO) finish the first day of trading well above the offering price, but many don’t. Anytime the discussion is about making money fast or easily, it smacks of speculating. It is all rather enticing but it isn’t as simple as it might seem.

First, it is common for headlines to read that a company went public at $X and closed at some number higher than $X. The bigger the difference, the more substantial the press coverage is likely to be. Coverage of one or more of these first day pops is probably what got your attention.

However, you must keep in mind unless you are an insider that was able to acquire shares before the IPO, you will only be able to buy shares once they become available to the public on the open market. If there is a lot of hype about the IPO, the first public trades may be at a price far above $X. It is common for people who bought shares on the first day they were available to soon be showing losses on their holding. Sometimes the losses are immediate. Jumping on an IPO as a quick moneymaking trade is fraught with risk.

Over the long haul, IPOs tend to lag relevant benchmarks of more established companies. Jay Ritter at the University of Florida studied IPOs over a 23 year period and found that they lagged similar sized firms by 5.6% a year. Another study by Dealogic found even in the tech-fueled 1990s, IPOs lagged the S&P 500
SPX,
-1.90%

by 7.9% a year. More recently, Dimensional Funds studied 6,632 U.S. IPOs that occurred from 1991 to 2018. The sub-period from 1991 to 2000 saw an average of 420 IPOs a year as the tech bubble inflated. The following 18-year period saw an average of 120 IPOs a year but also average three times the size of the prior sub period. In the aggregate the IPOs lagged the market in each sub period and the total period.

The cause of this aggregate underperformance is likely that so many first day prices were higher than justified by underlying fundamentals. The company is engaging in an IPO to raise cash by selling shares to the public and they want a good price for those shares. Your return is based on the price you pay versus subsequent prices. When you start off paying a high price, your result is likely to lag. This is why many academics would say people are better off thinking IPO stands for “It’s probably overpriced.”

If buying into an IPO when shares are publicly available is tricky, and the long-term results weak, why do so many people jump in on day one? From my experience, the most common reasons are for speculative trading purposes (looking for a pop in price) or they have convinced themselves that the company they are buying into will be above average over time and they want in as soon as possible. Most of the companies coming public have a gripping story about how they got to the point of an IPO and how bright their future is. Some will do well, of course, but the data suggest most won’t.

If you truly believe the company coming public will be a winner even if you pay a high price at first and you don’t bet too much of your life savings on that belief, jumping on an IPO may not become a problem. But if buying IPOs becomes a habit or you put too much of your savings at risk, you are probably asking for trouble.

If you have a question for Dan, please email him with ‘MarketWatch Q&A’ on the subject line. 

Dan Moisand is a financial planner at Moisand Fitzgerald Tamayo serving clients nationwide from offices in Orlando, Melbourne, and Tampa Florida. His comments are for informational purposes only and are not a substitute for personalized advice. Consult your adviser about what is best for you. Some questions are edited for brevity.

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