September 23

Some Inconvenient Truths on IPOs

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What could be more exciting than a well-known company floating its Initial Public Offering (IPO)? Tempted by the possibilities and often before the news even graduates from rumor to reality, investors clamor to climb on board the maiden voyage of a successful private company going public.

A case in point is Twitter’s September 12 announcement, released in a Tweet (of course), which swiftly winged its way around the globe:

“We’ve confidentially submitted an S-1 to the SEC for a planned IPO. This Tweet does not constitute an offer of any securities for sale.”

The news wasn’t confidential for long, as the financial press flocked to report on it. But what about you and your own nest egg? If the Twitter IPO takes flight, should you plan to include it in your portfolio? What about the next big IPO after that?

As fun as it may be to imagine making millions on a famous IPO,
we continue to recommend a wiser course for your life’s savings.

Remember, as a long-term investor, the object of the investing is to achieve your personal financial goals in the face of ever-present market uncertainty. We help investors accomplish this by building a portfolio according to the academic evidence on how to (a) best expect to capture market returns in accordance with personal risk tolerance, and (b) minimize the costs involved. Under these sensible criteria, IPOs simply don’t fit.

Parts vs. Whole

First, choosing individual stocks in general isn’t attuned with long-term investing. Think of stock-picking as the equivalent of taking pot shots versus aiming at a defined target for your aggregate wealth. A May 2012 New York Times article helps us understand why. The author interviewed Nobel laureate economist and father of Modern Portfolio Theory Harry Markowitz about the then-imminent Facebook IPO. He summarized Markowitz’s comments as follows:

The math behind [Markowitz’s work] is complex, but the basic thought is not. Rational investors ought to assemble rigorously diversified portfolios of stocks and bonds with a mix of risk and return optimized for their own needs and beliefs. … Forget about individual stocks like Facebook and buy broad low-cost stock and bond index funds instead. Allocate them in a proportion that gives you a level of volatility with which you are comfortable.

Whether it’s Facebook, Twitter or whatever popular bandwagon is yet to roll down the road, Markowitz’s advice remains perennially fresh.

Winners and Losers

Another disadvantage to purchasing IPO stocks in an attempt to hit the proverbial jackpot is that you’re playing a zero-sum game … which is a financial economist’s way of saying that for every stock-trading winner, there must be an equal and opposite stock-trading loser on the other side of the trade. That’s how individual stock purchases play out.

Experience shows that the most sought-after IPOs tend to be very narrowly offered, with only a select few receiving those spectacularly hot IPO returns you hear about. (Read: Probably not you.) Guess where their big winnings are coming from? Straight out of the pockets of whoever ends up buying their pricey trades. (Read: Could well be you.)

By taking a portfolio-focused approach to investing, you’re playing an entirely different game, with improved rules of engagement. By building a low-cost, globally diversified portfolio that reflects your personal goals and tolerance for market risk, you can efficiently capture whatever returns the market offers participants. As the market experiences overall expected growth, everyone who is patiently participating benefits from that growth as well.

The Evidence Is In: Odds Are Against You

What if you can stay put during a bumpy start and simply buy and hold an IPO, awaiting long-term performance? Why not give that a try? Strike three, as a rich body of evidence indicates that IPOs as a group tend to disappoint. 

  • In his November 2012 CBS MoneyWatch post, “Why IPOs Underperform,” financial blogger Larry E. Swedroe described and explained some of the latest academic thinking on the phenomenon of IPO underperformance.
  • Before Facebook’s well-publicized IPO adventures, Groupon became a rising star in 2011, when it went public amidst considerable fanfare. At the time, financial blogger Carl Richards published “Think Twice About That ‘Hot’ New IPO,” citing a heavy-hitting list of study after study substantiating his own apt conclusion: “What often gets lost when we get all excited about a hot new I.P.O. is the pesky fact that most of the time buying an I.P.O. is a great way to lose money.”

Speaking of Groupon, when is the last time you’ve heard anyone get excited over either its stock or its services? If the preponderance of studies don’t convince you, maybe real-life experience will.

Something to Tweet About?

It’s true, building and maintaining a sensible portfolio according to the academic evidence and your personal goals doesn’t give you much to Tweet about with your friends. But if it secures your financial goals as planned, you’ll be spending your days doing what you love with those you love the most. You may not have any time left to Tweet.


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About the author

Gardner is a CERTIFIED FINANCIAL PLANNER and principal of Sherrill Wealth Management in Bradenton, Florida. He has spent 20+ years in the wealth management field helping families negotiate the various obstacles and opportunities that retirement provides them.
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