Skip IPOs to Improve Your ReturnsA number of large privately owned companies made splashy debuts on the stock market this year. Some have been really good (Zoom and Beyond Meat). Some have been really bad (Lyft and Uber). Before you go chase the next Beyond Meat (up 244% in its first three weeks of trading), let’s review the long-term track record of investing in IPOs (Initial Public Offerings).
Professor Jay Ritter at the University of Florida has been studying the returns of IPOs for decades. The results of his research say it’s a risky proposition with returns that average out to 2% lower than comparable stocks (assuming you hold them for 5 years after the IPO). How does this happen? Many new stock listings jump dramatically in the first day, but most investors can’t get their hands on the shares at the initial listing price. They end up paying a much higher price later on the first day, which hurts future returns.
Then you run into the problem of insiders selling their shares after their lock-up period ends. Private stockholders aren’t allowed to sell all of their shares when a company goes public. These shares are locked up for a period of about six months. After that point, these people want to diversify their wealth and begin selling. This can cause the initial price jump to fizzle out. When the insiders who own a company (and know way more about its future prospects than anyone else) think it’s a good time to sell, maybe we shouldn’t rush in to buy it.
Against these odds, it’s not surprising that the average investor would have lost money in 60% of IPOs after the first five years (IPOs from 1980-2018). Don’t invest where the odds are stacked again you. Skip those IPOs and invest where the odds are tilted in your favor (index investing and factor investing).