Although investing in IPOs has the potential to be lucrative, there are several things you should consider prior to making any IPO investment. The general definition of risk is the possibility of losing money. Any investment has the possibility of loss; however those investments that bear more potential reward generally contain a larger amount of risk. It is because of this reward that investors decide to take on a certain amount of risk in their investments. There are several distinct types of risk involved when investing in shares. Certainly, IPOs carry all the same risks as investing in established equities, yet there are some additional considerations when investing in companies that are new to the securities market.
One factor inherent in all equity investments is market risk. This is the risk that the value of your investment will decrease due to movements in the overall market. Types of market risk can include equity risk, or the risk that the price of the shares will change, and equity index risk, or the risk that the share or other index prices will change adversely.
Another consideration is sector risk. Sector risk is the risk that all of the equities in an entire sector of the market will be effected by economic or other factors which pertain to that sector more specifically than other sectors. Therefore, within your equity investments, you need to hold a sufficient spread of sectors and industries such that a downturn in one part of the economy will not have too negative an effect on your entire portfolio.
Within all equity investing, there is also specific risk. This is the risk that comes with holding shares in individual companies. Regardless of the underlying economy or other market conditions, individual companies can go through bad times. If they do, then their share price is likely to drop.
Economic risk must also be considered when investing in any equity. This type of risk is associated with the overall health of the economy of the country or the locality where the investment was made. It is essentially the risk that the economy could potentially turn against your investment.
IPO Unique Risks
There are risks unique to investing in IPOs. For example, whereas with already listed equities you have the ability to research observable historical share prices, IPOs do not offer that luxury. As these shares are new to the stock exchange, there is no way to check past trends.
As covered in a previous section, three of most important criteria to asses an IPO are:
- Demand for the IPO. This is probably the most important consideration. We want to invest in the IPOs that everyone else wants to invest in! You can see the obvious problem with this; the better the IPO, the harder it is to get an allocation. Generally the best IPOs are only accessible through a stockbroker.
- Quality People. You should favor companies whose directors and senior management have a history of business success. Some people have a habit of creating shareholder wealth and naturally we should give preference to companies they are involved in.
Scalable Business Model. Capital markets seem to like business models with significant ‘blue sky’; the market is more likely to get excited about such a company versus a company that has limited or modest growth prospects.