Initial public offerings (IPOs) involve a great deal of uncertainty, which makes them a relatively risky investment. Thus, investors should receive higher expected returns as compensation for the greater amount of risk that’s associated with them. However, the evidence shows that unless you are well-connected enough to receive an allocation at the IPO price (and then get out quickly), IPOs make poor investments.
Professor Jay Ritter of the University of Florida has done a series of studies on IPO performance, which you can find on his website. His most recent study, updated in April 2015, covered the period beginning in 1980 and includes returns data through 2014.
Comparing IPO returns after the first day’s trading to similar listed stocks, Ritter found that, on an equal-weighted basis, they underperformed other firms of the same size (market cap) by an average of 3.1 percentage points per year during the five years after issuing (not including the first-day return).
The underperformance relative to other firms of the same size and book-to-market ratio averaged 2.0 percentage points per year. Clearly, investors were not rewarded for taking on the incremental and idiosyncratic risk of IPOs. So what’s going on? There are two explanations in the literature: the lottery effect and the winner’s curse.
The Lottery Effect And The Winner’s Curse
Investors display a preference for “skewness” in returns, meaning they’re willing to accept the high probability of a below-average return in exchange for the small chance of earning an outsized return should they find the next Google.
This is what’s frequently referred to as the “lottery effect.” Investors tend to place high subjective valuations on large but low-probability gains. The lottery effect phenomenon becomes especially pronounced in times of high investor sentiment. Due to a positive skewness of returns and high valuations at the beginning, these IPOs tend to underperform in the long run.
Eric Falkenstein explains the winner’s curse in his book, “The Missing Risk Premium.” Let’s say you have to guess the number of jellybeans in a jar. If you average together the guesses of a large crowd, it usually ends up being very close to the actual number. While some individual guesses can be off by a wide margin, the really low guesses offset the really high guesses.
Now imagine this group in the context of an auction. Averaging together the maximum price that each individual would pay for an item would give you a very close approximation of its true value.
But that’s not the way an auction works. The person who wins the auction is the one willing to bid the highest. That’s obviously higher than the average price (or approximate value) of the item, meaning the person will almost certainly overpay for it.
With a stock, some investors will value it higher than the market average, and others will value it lower. That balance is what gives stocks their price. However, IPO stocks may not have that same dynamic for a few reasons: