IPO can lead to risky investing

All investors probably wish they had gotten in on the “ground floor” of Apple or Microsoft or any other big success story. And, in fact, you can indeed “be there from the beginning” by taking part in a company’s initial public offering (IPO). However, the ground floor of many IPOs may be shakier than you’d think — and might not provide you with the solid footing you need to invest wisely.

Of course, not all IPOs are the same. Many large, profitable companies, seeking to raise capital, have gone public in recent years through IPOs. However, IPOs of newer, unproven companies share some characteristics that should give pause to serious, long-term investors. Consider the following:

Hype — Let’s face it: A big part of the appeal of IPOs is the “wow” factor. It looks really cool when the company’s CEO — or perhaps a visiting celebrity — rings the opening bell at the New York Stock Exchange. And the rush to buy shares in the now-public company always garners big headlines. Yet “hype” is just one letter removed from “hope” — and hope alone is not a good reason to invest. Furthermore, no single stock — even one that might have strong growth potential — is likely going to be the ticket to investment success.

Lack of track record — By definition, newer companies that launch IPOs don’t have long track records. And while it’s true that “past performance can’t predict future results,” it’s nonetheless useful to see how a stock has performed in various economic climates and how the company management has responded to different challenges over time.

Exceptional volatility — All stocks fluctuate in value. But IPOs tend to be especially volatile — not just in their first few days of trading but also in their first few years of availability to the public.

Higher risk potential — Generally, IPOs of newer companies are better suited for aggressive investors — those who can handle a higher degree of risk in exchange for potentially higher returns.

Nonstandard accounting — Some IPOs, particularly Internet start-ups, use nonstandard, or “customized,” accounting measures to depict their companies in the best possible light. While these measures are not illegal — and in some cases, may even be useful in illuminating a company’s performance — they tend, overall, to make it more difficult for potential investors to accurately evaluate a business’ profitability, or at least potential profitability. At the end of the day, good old-fashioned profits and cash flow are still the key driver of companies’ stock prices.

As an alternative to pursuing an IPO, you could use any extra “investable” money you may have to fill gaps in your current portfolio, based on your goals. Or, if you are truly attracted to the type of business in which an IPO is involved, you might want to consider investing in a more established company in the same industry.

Taking part in an IPO sounds fun and exciting. But as we’ve seen, IPOs can have some serious drawbacks. And while it may not sound glamorous, a steady approach to investing — one that involves diversification, responsiveness to one’s risk tolerance and a constant focus on both short- and long-term objectives — is usually the right choice for most of us.

Doug Drost is a certified financial planner for Edward Jones, 2262 Reno Highway.