In multiple previous posts (see posts at link below for more details), I have made the case for why holding index mutual funds is a far superior strategy for individual investors than buying and selling individual stocks.
My Money Blog – Individual Stocks vs. Index Mutual Funds
However, in these postings, at no point did I address the issue of whether or not IPO’s (or Initial Public Offerings) make for good investments. This will be the topic of today’s post.
To begin this analysis, we first need to start with defining what an Initial Public Offering, or IPO, is exactly.
What is an IPO?
According to Investopedia.org, an IPO can be defined as shown below:
- “The first sale of stock by a private company to the public. IPOs are often issued by smaller, younger companies seeking the capital to expand, but can also be done by large privately owned companies looking to become publicly traded.”
Typically, the company going public will team up with an underwriter (usually an investment banking firm) that will help the company the timing of when to begin selling shares of stock on the public market and what price at which to offer them.
Now that we have an idea of what an IPO is, let’s take a look at how they have performed against the test of time.
Performance of IPO’s Over the Years
As you might have guessed, according to academic research supporting the Efficient Market Hypothesis (place link to investopedia.org here), since IPOs are individual stocks, they are already, by nature, less effective than index mutual funds.
So, let’s say that is “Strike 1” against IPOs.
“Strikes 2-5” come to us from four studies cited in Larry Swedroe’s book titled, The Only Guide to a Winning Investment Strategy You’ll Ever Need. The results of these studies are summarized below:
- Study 1
- Strategy – buying every IPO from 1970-1990 at the closing price of the 1st day of trading for an IPO and then holding each for 5 years.
- Results – IPO investments performed 7% below benchmark performance of companies with comparable market capitalization already trading.
- Study 2
- Strategy – buying every IPO that rose as least $20 million from 1988-1993 (1,006 IPO’s).
- Results – Underperformed Russell 3000 index by 30% in the three years after going public. In addition, 46% of the IPOs produced negative returns.
- Study 3
- Strategy –Buy all IPO’s issued in 1993 and hold until mid-October 1998
- Results – Found that the average IPO returned 67% less than the S&P500 index.
- Study 4
- Strategy – Buying all IPOs that rose 60% or more on their opening day and then holding from 1988-1995.
- Results – Underperformed market by 2-3% per month (24-36% per year). Wow!
As you can see from the pitiful under-performance above, IPO’s, even though they are a very exciting investment option, are definitely not the best choice for individual investors.
By all practical terms, you will never have sufficient knowledge that you would need in order to make an informed purchasing or selling decision with IPOs. Due to this very strong reasoning, IPO’s are best to be avoided by individual investors.
If you do enjoy the excitement that IPOs offer, there is no problem with using a small amount of funds to buy IPOs and place them in the Play Money portion of your portfolio.
For more information on Play Money/how to work IPO’s in to your investment strategy, please click on the link below.
Personally, I have never invested in an IPO, and therefore, am curious to learn about experiences you all have had with them.
Please feel free to post a comment below and tell everyone how an IPO fared for you!
Keep on learning!
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