Let’s say you’ve taken my advice and most of your portfolio is comprised of low-cost, passively managed, globally diversified mutual funds. You agree this is the right way to go but, let’s face it, sometimes the tried-and-true can be boring.
Now a friend of yours is really excited about an Initial Public Offering (IPO). In an IPO, a privately owned company issues shares of its stock to the public for the first time. It’s tempting to think of an IPO as the ground floor of a great opportunity, like Apple when it was still operating out of Steve Jobs’ and Steve Wozniak’s garage. The siren song of vast profits tempts us.
[See Tom’s research on the accuracy of stock predictions]
So do IPOs make sense as part of the average investor’s investment strategy? Sorry, the answer is no, and here are a couple of reasons why.
As a group, IPOs’ performance disappoints. A seminal paper published in The Journal of Finance looked at IPOs from 1970 to 1990. During the five years after issuance, investors in these IPOs got average annual returns of only 5%.(1) By contrast, the overall stock market’s average annual return from 1970 to 1990 was more than double that figure, at 10.8%. To put this in perspective, $1,000 invested at 5% for 20 years would have generated $2,653, while $1,000 invested at 10.8% would have generated $7,777, almost three times as much.
The subpar return on IPOs makes sense when you realize that the issue price for the shares is set by the issuer and the investment bank it hires to market the shares. Both obviously know more about the stock than the public does, and both have financial incentive to charge the maximum price the market will bear. Moreover, IPOs tend to come out at peaks in the market. To illustrate, during the recent financial crisis from 2007 to 2009, there were almost no IPOs. That’s because with the market as low as it was, it didn’t offer enough of a payday to the issuers and investment banks. They wait for better times. Now that the market has almost doubled from its lows in 2009, we are starting to see some IPO activity.
Thus, IPOs as a group are a bad investment when compared with the overall stock market. Sure, you might get lucky, making a killing on the next Microsoft. But that, my friend, is just gambling. And just like gambling in Las Vegas, gambling in IPOs is a loser’s game. On average, over time, the odds are against you.
(1) Loughran, Tim and Ritter, Jay R., The New Issues Puzzle. JOURNAL OF FINANCE, VOL. 50, NO. 1, MARCH 1995. One of the study’s authors later updated the data to take in the period 1980-2008. The updated study showed similar results, demonstrating that IPOs underperformed other firms of the same size (market capitalization) by an average of 3.5% per year during the five years after issuance. Interestingly, the author excluded from performance the stock’s first-day return because so few investors actually can buy on the first day.