When it comes to investing, we all want to hit the home run. Not many people are interested in buying shares of General Electric and holding them for decades, earning a decent return along the way. No we want to buy a stock and see its price double by next weekend. Unfortunately, the odds of this happening are rare and even rarer are the odds you actually own the one stock that does double overnight.
But we are still drawn to the allure of this happening. This is the main reason we jump on IPOs. Sadly though, history has shown us that we are better off skipping the IPO market entirely and just focus on good companies to buy for the (boring) long-term.
What Is An IPO?
For those new to this term, an IPO is an initial public offering of a stock. A famous recent IPO was Facebook. Up until a few years ago, they were a privately held company. The only shareholders were the executives and any private investors that helped to get the company off of the ground.
When a company decides to go public, they face a variety of legal hoops to jump through and eventually a date is set when the shares will begin trading publicly. The first day of public trading is usually insane.
This is because everyone wants to get their hand on some of the stock. They feel like this is the best time to buy. In reality though, it is the worst time to buy for 2 main reasons.
If you think back to your economics class, you know that supply and demand are related and the greater the demand for an item, the higher the price will be. This is an IPO in a nutshell. Everyone wants a piece of the action and are willing to pay whatever for it. This demand drives the price up, most times to levels that aren’t sustainable once rational minds prevail (and they will).
Take Alibaba for example. On its first day of trading, the price rocketed up 38%. People gave into their emotion and bought, no matter the cost.
When a company is publicly traded, anyone can see their financials and analyze the numbers to determine if the stock is a good buy or not. Along with this, you will have many people doing their own analysis and they might see something you don’t or vice versa.
When a company is going public, you don’t have to opportunity to look at years’ worth of financial statements, nor do you have the same number of people running the analysis to make the determination if it is a buy or not. Because of this, you run the risk of missing an important fact or number which can tell you to do the wrong thing.
Investing For The Long-Term
The only real way to be consistent with making money in the stock market is to buy solid companies and hold the stock for the long-term. And by long-term I am talking about many years. Take Alibaba for example. Even after their run up on the first day, the stock is currently trading for less than what it closed at. The hype and demand are gone and more people are crunching numbers, realizing the stock is overvalued.
While there are exceptions to the points I made above, the fact remains that in most cases, buying an IPO is not a wise decision financially. If you insist on doing so, use money that you are comfortable with losing because odds are after that first day, the stock is going to drop and it will take time to recover.