The Allure and Reality of IPO Investing
Initial Public Offerings (IPOs) have a certain allure for investors. The media hype, the promise of getting in on the “ground floor,” and the stories of massive first-day gains can make IPOs feel like an irresistible opportunity. But the data tells a more sobering story. For long-term investors, IPOs are often a poor bet compared to simply holding a diversified investment portfolio of existing public companies.
The Hype vs. The Reality
When a company goes public, it’s often surrounded by a media frenzy. The underwriters, the company executives, and early investors all have an incentive to generate as much excitement as possible. This can lead to outsized first-day price pops, which are great for those who bought at the IPO price – but that’s a small and exclusive group. Most everyday investors only get access after the initial trading begins, often paying inflated prices.
More importantly, academic research and market history show that IPOs as a group tend to underperform the broader market over the long term. Once the initial excitement wears off and the company’s fundamentals are more closely scrutinized, many IPO stocks see their prices stagnate or decline (Ritter, 1991).
Why IPOs Tend to Underperform
Several factors contribute to the disappointing long-term returns of IPOs:
- Valuation Pressure – IPOs are often priced aggressively to maximize proceeds for the company and its early investors. High starting valuations leave little room for upside.
– Reminder: The company leading an IPO is obligated to act in the best interests of its existing private shareholders – which means aiming to sell the newly issued public shares at the highest possible market price they can reasonably get.
- Insider Selling – IPOs frequently serve as an exit strategy for founders, venture capital firms, and other insiders. Their selling can put downward pressure on the stock.
- Market Timing – Companies tend to go public when market conditions are favorable and their financials look strong. This often coincides with peak valuations.
Practical Takeaways for Investors
For most investors, IPOs should be approached with extreme caution. Rather than chasing the latest high-profile company, it’s generally wiser to stick with a diversified, low-cost investment strategy that captures potential broad market’s returns.
Academic Perspective: IPO Performance Research
Extensive research has examined IPO performance across different markets and time periods. One landmark study by Ritter (1991) analyzed the long-run performance of IPOs in the U.S. and found that, on average, IPOs underperformed a comparable set of non-issuing firms by about 20% over three years. Subsequent research across global markets has replicated this finding.
– “In the long run, IPOs underperformed. Possible explanations for this underperformance include (1) risk mismeasurement, (2) bad luck, or (3) fads or overoptimism” (Ritter 1991)
Theories explaining this underperformance include investor over-optimism, information asymmetry, and the deliberate timing of offerings to coincide with peak valuations. While there are exceptions – notable companies that delivered exceptional post-IPO returns – the aggregate data strongly supports the conclusion that IPOs are generally poor long-term investments (Ritter, 1991).
For Canadian investors, the same caution applies. While our IPO market is smaller, the underlying dynamics of pricing pressure, insider incentives, and market timing remain similar.
Disclosures:
Important information about mutual funds is found in the Fund Facts document. Please read this carefully before investing. Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Mutual funds are not guaranteed, their values change frequently, and past performance may not be repeated. Unit values and investment returns will fluctuate.
The information provided is based on current laws, regulations and other rules applicable to Canadian residents. It is accurate to the best of our knowledge as of the date of publication. Rules and their interpretation may change, affecting the accuracy of the information. The information provided is general in nature and should not be relied upon as a substitute for advice in any specific situation. For specific situations, advice should be obtained from the appropriate legal, accounting, tax or other professional advisors.
References:
- Ritter, J. R. (1991). The long-run performance of initial public offerings. The Journal of Finance, 46(1), 3–27. https://doi.org/10.1111/j.1540-6261.1991.tb03743.x
Stick to a plan. Stay diversified. Keep costs low. Avoid the noise.
And remember: boring investing is often the most effective.
