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Why Buy IPO Stocks?

For the most part, people are risk averse. We prefer not to take on any additional risk unless there’s an increase in expected return.

On occasion, however, we’re not risk averse. We’re risk seeking. When we go to a casino or play the lottery, we’re taking on risk despite the fact that our bets have a negative expected return.

Why? Because in some contexts, risk is fun. It’s entertainment.

Picking Stocks for Fun

Many investors like to pick stocks for fun. For them, attempting to outsmart (and outperform) the market is an enjoyable intellectual challenge. (And for the record, I see nothing wrong with that, as long as they’re aware that the value is in the entertainment rather than in the likelihood of success.)

But what does this have to do with those of us who are buy and hold investors, who have no interest in picking stocks? In short, we may want to attempt to avoid investments that carry a high entertainment value.

The most obvious examples of such investments are penny stocks and IPOs. Because so many people use them like lottery tickets, their long-term historical returns (as a group) are rather low, despite their high risk.

Further, some experts–William Bernstein in The Investor’s Manifesto, for instance–argue that a part of the reason for value stocks having slightly higher historical long-term returns than growth stocks is that growth stocks (especially small-cap ones) carry a higher entertainment value than value stocks.

In other words, it’s fun to try to pick the next Microsoft or the next Google, so many people try to do exactly that. And in the process, they drive prices of small-cap growth stocks upward and returns downward.

The natural response, of course, is to actively seek to make your stock portfolio as boring and unglamorous as possible. The less popularity or entertainment value an investment has, the better.

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Comments

  1. I absolutely buy all this post. As well as entertainment factor, there’s also a related feel good value to buying ‘attractive’ stocks versus ‘ugly’ value stocks.

    For instance, I currently hold a big UK housebuilder called Berkley Group, that’s trading at 1/3 of its previous highs. About 1/4 of its market cap is underwritten by net cash, it was profitable operations-wise throughout the downturn, it has great management and a superb track record of navigating past economic cycles.

    And yet a bit of me knows I prefer to hold it to ‘rabbit hutch’ volume housebuilders because I like it’s elegant refurbishments and brownfield redevelopment more than the beaten-up mass-market housebuilders that will doubtless overtake it again in the next upswing.

    As you say, my stock picking is down with the full knowledge I may do worse than simply dripping into an index (which I also do with another big chunk of my portfolio) and an attempt at awareness of these foibles!

    You could set yourself up a little Sharebuilder account with $1000 in it Mike, presuming you guys have the $1.50 purchasing option, too.

    Just for fun… 😉

  2. It seems to be a given that if you pick individual stocks you will lose. This isn’t strictly true. What the data shows is that the average investor will underperform.
    It is worth remembering that people have bought stocks and made a killing! There are secretaries and mail room guys at just about every major corporation who today are millionaires just because they sunk every penny they had into the company they worked for whether it was IBM or Microsoft. Did they take on a lot of firm specific risk? Sure. But they won big. So, people don’t pick stocks just for the entertainment value.
    Just for the record- I recommend at least 80% invested in low cost, indexed ETFs and stress that most stock pickers will underperform.

  3. I agree with you! It seems also that “the flavor of the month/year” in term of stock will more likely grow up faster than it should be.

    When you look at RIM a few years ago, Apple (more recently), they have shown an important growth because they were “trendy stocks”.

    At one point, people buy a stock because it goes up. and the stock goes up because people buy it… market efficiency, huh?

    I prefer to stay away from IPO’s since they usually drop once you can buy them!

  4. I prefer to stay away from IPO’s since they usually drop once you can buy them!

    Really? Then short them every time and make a fortune.

    Not as clear cut as your narrative in my view, my friend. If it was easy we’d all be traders, not long-term investors into trackers. 😉

  5. @ Monevator,

    I meant that they usually drop during the first day once the “hype” is over.

    but I agree with you that it’s not that obvious and it doesn’t always happen this way! If not, I would have short sell every single IPO’s !

  6. Grand — understood! 🙂

  7. My understanding is buying an IPO inst always a smart move since by the time it comes for an IPO the stock/company is already over valued anyways.

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