Investors have just gotten over the hype surrounding Twitter’s initial public offering, but Wall Street’s IPO mania is hardly over. According to Renaissance Capital, some 230 companies will go public this year — making it the busiest year for IPOs since 2000.
We all know it’s easy for investors — institutional and retail — to get caught up in the IPO frenzy. After all, who doesn’t like the idea of getting in on the next Apple (AAPL)?
But as Bob Seawright, chief investment and information officer at Madison Avenue Securities, and publisher of Above the Market blog, points out: “There is broad, deep, and excellent research documenting the long-term underperformance of IPOs.” (See: “The Long-Run Performance of Initial Public Offerings.”)
That, he adds, is why “so many lottery tickets are sold despite incredibly long odds.”
Michael Kitces, director of research at Pinnacle Advisory Group and publisher of The Kitces Report, points out that when an IPO has a big price pop, “the company doing the IPO has just lost out on a huge chunk of money, as their shares were ‘underpriced’ to those who actually bought the IPO, and a huge portion of the value got transferred from the company to those institutions and key clients lucky enough to get access to the IPO shares (which are rarely advisors and their clients). In turn, those retail investors who buy an IPO on the open market on the first trading day essentially get the worst of all worlds — they buy at the highest price, and they buy shares in a company that missed out on a huge pile of cash to put towards its growth (in the case of Twitter, to the tune of a whopping $1.3 billion).” (For more on this, see Kitces’s latest blog post: The Idiocy Of The IPO Price Pop.)
So how does one counsel clients on investing in the midst of a hot IPO market?
“For those who are convinced that any particular IPO will be ‘the one’ (after all, it might be), I encourage them to understand both the risks and the odds before they buy, and that they only buy with money they can afford to lose,” Seawright says. “It’s like going to Vegas. The lavishness of the casinos demonstrates that the odds favor the house. But, if you only play with money you can lose (perhaps out of your entertainment budget), it’s not quite so bad.”
This idea of having a separate pool of money — money you can afford to lose — is an approach that Carl Richards, a certified financial planner and director of investor education for the BAM Alliance, also advocates. But only after having a thorough discussion with the client about why he or she wants to invest in a particular IPO in the first place.
The starting point for any conversation, though, is reminding clients about maintaining a diversified portfolio. “No individual equities. Period. IPO or not,” Richard says. “That’s shot across the bow number one.” But if that doesn’t work, he reminds the client about his or her investment plan and points out it doesn’t call for “speculative gambling.”
“If that doesn’t work, I always like to pull out the IPO data. And it’s more akin to gambling than it is to investing, and hopefully that works,” he adds.
And if it doesn’t? Then Richards suggests the client set aside a little money specifically for investing in IPOs and that the pot of money be labeled appropriately. “We’ll call it your gambling money, or your IPO money, we will call it whatever you want,” he says. The point is that it’s a limited amount, and if the client loses it, it won’t derail the broader plan.
Richards says it’s important for financial advisers to have an honest conversation with the client about why he or she wants to buy shares in the IPO and to try to understand the motivation. Using Twitter (TWTR) as an example, the conversation might go something like this:
Adviser: So, let’s talk about this. Is this about investing or is this about entertainment? Why do you want to own Twitter?
Client: Well, because everyone else is.
Adviser: Well, I totally get that, but that is not an investment goal, that’s called peer pressure.
Client: Well, because I think it’s going to be a great stock.
Richards says “you have to try keeping asking why, and why, and why, and most of the time it seems they work themselves out of it.”
But say a client says something along the lines of: “I honestly believe Twitter is going to change the world, and I just wouldn’t be able to handle the regret.” Then the adviser needs to be more nuanced in his or her response, as for this particular client, it may be worth spending a little bit of money to avoid that regret.
The adviser’s job is to keep asking why and then drill down and expose and understand the underlying motivations for why the client wants the shares.
Richards says the starting point for these types of conversations is “a rational investment plan that was based on goals and values and built when people were thinking rationally.”
Anytime anyone wants to deviate from a financial plan or an investment policy statement based on anything other than a change in their circumstances or goals (say an inheritance), it’s important to remind the client of the plan, and if the goals haven’t changed, the investing approach shouldn’t either.
“Whatever that document represents, whether a financial plan or an investment policy statement, that becomes the touchstone — pull that document out and remind yourself why you are investing the way you are, and if all those things are still true, take a deep breath and move on,” Richards says he tells clients. “It’s almost always simply the number one job of a good adviser to remind clients of what they said when they were thinking rationally. Carefully remind them of that and then by the end of the call I can’t tell you how many times I’ve heard, ‘Uh Carl, forget I called.’”
So, to recap, here’s a five-step process:
- Ask: “Why this IPO?” Keep asking why until you get to the bottom of the client’s motivation/reasoning.
- Point out the data on the track record of IPOs and review the risks and odds of success.
- Present the client’s financial plan or investment policy statement and have him/her review the goals. Ask: “Has anything changed?”
- If the client insists on moving forward, carve out a separate, limited pool of funds that he/she can afford to lose and label it appropriately (e.g., “play money”).
- Wish the client “Good luck!” (It’s a gamble, after all.)
Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.
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