The Risks of IPOs

It sounds like a one way ticket to financial glory. Buy stock in a company that goes public and you can't lose, right? Guess again. An initial public offering (IPO) allows a company to access capital from the public markets. The capital raised can be used to pay down debt or to grow the business. From management’s perspective, it can be a good thing. On the other hand, an investor needs to understand the risks before diving into an IPO.

When discussing IPOs, it's important to distinguish between the IPO price and the opening price. The IPO price is determined before the shares even start trading and only a select few are afforded the privilege of buying these shares. Large institutional funds and high net worth individuals are more likely to receive share allotments in the IPO. The rest of the public waits for the stock to start trading and buys at the open price. This price can be significantly higher than the IPO price which means that the people who bought at the IPO price are laughing all the way to the bank. Buying shares after they begin trading isn't necessarily the worst thing. Plenty of companies trade higher from that point but it the ride can be a bumpy one.

The greatest risk associated with IPOs is the volatility associated with them. Since investors are still learning about a company's business and expected performance, the stock price can bounce considerably. Eventually, most stocks will settle into a more stable trading range which can be more attractive to the risk averse investor.

Reuben Advani is the president of The BARBRI Financial Skills Institute and the author of two finance books. More information on this and other topics can be found at http://legalpractice.barbri.com.

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