Wednesday, 27 June 2012

Be Wary of IPOs. It's Probably Overpriced.

Do you think you can make lots of money by getting in on the ground floor of the initial public offering (IPO) of a company just coming to market?

My advice is:
  • that you should not buy IPOs at their initial offering price and 
  • that you should never buy an IPO just after it begins trading at prices that are generally higher than the IPO price.  
Historically IPOs have been a bad deal.  In measuring all IPOs five years after their initial issuance, researchers have found that IPOs underperform the total stock market by about four percentage points per year.  
  • The poor performance starts about six months after the issue is sold.  
  • Six months is generally set as the "lock up" period, where insiders are prohibited from selling stock to the public.  
  • Once that constraint is lifted, the price of the stock often tanks.
The investment results are even poorer for individual investors.  You will never be allowed to buy the really good IPOs at the initial offering price.  The hot IPOs are snapped up by the big institutional investors or the very best wealthy clients of the underwriting firm. 

If your broker calls to say that IPO shares will be available for you, you can bet that the new issue is a dog. 
  • Only if the brokerage firm is unable to sell the shares to the big institutions and the best individual clients will you be offered a chance to buy at the initial offering price.  
  • Hence, it will systematically turn out that you will be buying only the poorest of the new issues.  
  • There is no strategy I am aware of likely to lose you more money, except perhaps the horse races or the gaming tables of Las Vegas.

A Random Walk Down Wall Street
by Burton G. Malkiel

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