Is it time to get your IPO dancing shoes on, then?

IPOs can be exhilarating – with their buzzy young companies, massive growth potential, and the thrill of being part of the next big thing. And the success of recent high-profile listings like Reddit might even have you thinking IPOs are a one-way ticket to riches.

But here’s the thing: the hard data paints a less glamorous picture and shows that excitement doesn’t always mean a smart investment. See, despite those first-day trading spikes, research by “Mr. IPO” Jay Ritter suggests that IPOs tend to have a poor long-term track record for investors. From 1980 through 2022, the majority of IPOs lost money over the three- and five-year periods that followed their debut, with 37% losing more than half their value over three years. He found that the average IPO stock bought at the publicly available closing price on the first trading day returned about 6% annualized over three years. Meanwhile, an index of all U.S.-listed stocks returned about 11% annualized over the same period. Put more simply, buying the index would have been more profitable.

There are a couple of reasons why IPOs don’t live up to the hype. For starters, most investors can’t buy in at the offer price. These shares are typically reserved for big institutional players. For the average investor, getting in at this stage just isn’t possible. And, usually, by the time these stocks make their grand entrance on the open market, their prices have already spiked. So regular investors are probably buying in at prices that are way less juicy. And that can have a huge effect on returns: Ritter found that jumping in at the first day’s closing price, rather than the initial offer price, can slash three-year returns by nearly half.

Another reason is the existence of lock-up risk: bigwigs like founders, employees, and early bird investors are usually handcuffed from selling their shares for a few months post-IPO. And once that lock-up period ends, there’s often a mad dash to sell, flooding the market with shares and driving the price down. And don’t forget about the tug-of-war in interests, with venture capitalists, underwriters, and early investors itching to cash out big at the IPO.

Behavioral biases also increase the risk of an overhyped company trading above its fundamental value. After all, many investors forget that for every Tesla, there is at least one WeWork (the company lost 99% since its 2021 debut and recently filed for bankruptcy). There’s a reason why legendary investor Warren Buffett has called investing in IPOs “a stupid game”.