After several quiet years, the IPO market is back. Every week seems to bring another company going public at an eye-catching valuation, and the headlines are hard to miss.
It’s only natural to wonder: Should I try to get in?
It’s a question we’ve been been hearing from clients, and as a general rule, we don’t recommend participating in IPOs. That has very little to do with any one company. It has to do with how IPOs actually work and what history tells us about the odds.
Let’s Start with the So-Called “IPO Pop”
The “IPO pop” is the jump between the offering price and where the stock first begins trading.
The pop is real. The problem is that it’s rarely yours to capture.
Buying shares at the IPO price usually requires an allocation from the investment banks underwriting the offering. Those allocations typically go to large institutional investors and the banks’ biggest clients. By the time most investors can buy shares on the open market, the price has often already moved significantly higher.
Ironically, the IPOs that are easiest to get into are sometimes the ones with the weakest demand.
What About the First Year?
The first day gets all the attention, but it’s what happens afterward that matters. Research from Dimensional which examined more than 6,000 U.S. IPOs, found that IPOs, as a group, have historically underperformed the broader market. Newly public companies often share characteristics such as smaller size, rapid growth, and lower profitability—traits that have historically been associated with lower expected returns.
There’s another wrinkle. Early investors and company insiders are usually prohibited from selling their shares immediately after the IPO. These “lock-up” periods often last six months to a year. When they expire, a large number of additional shares can enter the market, increasing supply and sometimes putting downward pressure on the stock price.
Keep the Big Picture in Mind
None of this means IPOs are bad investments. Some newly public companies will become extraordinary businesses. The challenge is that no one knows which ones those will be.
One of the benefits of a diversified investment strategy is that you don’t have to guess. If a company goes on to become highly successful, there’s a good chance you’ll own it
eventually anyway. As companies grow and become established, many are added to major market indexes and naturally become part of diversified portfolios.
That’s one of the reasons we encourage clients to focus less on getting in early and more on staying invested. Building long-term wealth isn’t usually about finding the next hot stock. It’s about owning a broadly diversified portfolio, keeping costs low, and having the discipline to stick with your plan through changing markets.
IPOs will come and go. The headlines will change. But the principles of successful investing remain remarkably consistent.
If you have questions about a particular IPO—or whether it belongs in your portfolio—we’re always happy to talk it through.