Why IPOs Can Be High Risk—and When Long-Term Investors Should Consider Them.

When a well-known company announces that it is going public, the excitement can be difficult to ignore. News coverage increases, investors begin discussing the company's potential, and the possibility of buying shares early can make an Initial Public Offering (IPO) seem like a unique opportunity.

However, being early does not necessarily mean getting a good investment.

For long-term investors, IPOs can present opportunities, but they also carry risks that differ considerably from those of investing in established publicly traded companies. Understanding those risks—and knowing when patience may be the better strategy—can help investors make more informed decisions.

What Is an IPO?

An Initial Public Offering (IPO) occurs when a privately owned company begins offering its shares to the public for the first time. Before an IPO, ownership is generally concentrated among founders, employees, venture capital firms, private equity investors, and other private investors. Going public allows the company to raise capital while also giving public investors an opportunity to become shareholders.

The IPO itself is not necessarily the problem. The challenge for investors is determining what the business is actually worth and whether the price they are paying is reasonable.

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Why Can IPOs Be High Risk?

1. Limited Public Trading History

An established public company may have years—or even decades—of quarterly earnings reports, financial statements, and market performance for investors to evaluate.

A newly public company has significantly less history as a publicly traded business.

Although investors can review the company's IPO filings and historical financial information, they do not have as much public-market data to evaluate how management performs across different economic and market environments.

For long-term investors, that uncertainty matters.

2. The IPO Price May Reflect High Expectations

A great company is not automatically a great investment at every price. IPO valuations can sometimes incorporate aggressive assumptions about future revenue growth, profitability, market share, or industry expansion. If the company performs well but fails to meet those elevated expectations, its stock price can still decline.

Consider a simplified example:

A company goes public at $50 per share because investors expect extremely strong future growth. Excitement pushes the stock to $75 shortly after the IPO. Several quarters later, the company continues to grow—but more slowly than investors expected. The stock falls to $45.

The business may still be healthy. The problem was that investors initially paid a price that assumed even stronger results. Price and value are not always the same thing.

3. Early Price Volatility Can Be Significant

IPO stocks can experience substantial price swings during their first several months of trading.

Demand from institutional investors, retail investors, short-term traders, media attention, analyst opinions, and changing expectations can all influence the stock price.

For a long-term investor, this creates an important question:

Do I need to own this company immediately, or can I wait until the market has had more time to evaluate it?

Sometimes patience provides additional information without materially changing a long-term investment opportunity.

4. Profitability May Still Be Years Away

Some companies enter the public markets while they are growing rapidly but are not yet consistently profitable. That does not automatically make them bad investments. Many successful companies invested heavily in growth before producing substantial profits.

However, an investor should understand how the company eventually expects to generate sustainable earnings and cash flow.

Revenue growth by itself does not guarantee shareholder returns. Long-term investors should evaluate factors such as revenue growth, profit margins, free cash flow, debt, competitive advantages, customer concentration, and management's capital-allocation decisions.

5. Insiders May Eventually Be Able to Sell

Founders, employees, and early investors typically cannot sell all of their shares immediately after an IPO. Their shares may be subject to a lock-up period.

When those restrictions expire, additional shares can become available for sale.

That does not necessarily mean insiders are abandoning the company. Early investors and employees may have legitimate reasons for diversifying their wealth. However, a significant increase in shares available for sale can create additional pressure on the stock.

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The Fear of Missing Out

One of the biggest risks surrounding IPO investing may be behavioral rather than financial.

When investors hear stories about a newly public stock increasing dramatically, it can create a sense that they must act immediately. This is Fear of Missing Out (FOMO).

Long-term investing should generally be based on fundamentals rather than excitement.

Instead of asking:

"How much can this stock go up?"

Consider asking:

"Would I still want to own this business if the stock market closed tomorrow and I couldn't sell it for several years?"

That shifts the focus from short-term price movements toward long-term business ownership.

When Might a Long-Term Investor Consider an IPO?

Avoiding every IPO is not necessarily the answer. Instead, investors can establish criteria to determine when an opportunity warrants further consideration.

An IPO may warrant additional research when:

• The company has a business model you understand.

• Revenue growth appears sustainable rather than dependent primarily on hype.

• The company has a credible path toward profitability and positive cash flow.

• Debt and other financial obligations appear manageable.

• Management has demonstrated responsible capital allocation.

• The company possesses a meaningful competitive advantage.

• The valuation appears reasonable relative to its growth prospects and risks.

• The investment fits within your overall portfolio and risk tolerance.

• You are prepared to hold the investment through substantial volatility.

  
  

Most importantly, the investment should make sense without relying on the assumption that another investor will quickly pay a higher price for your shares.

You Don't Have to Buy on Day One

Long-term investors sometimes believe that waiting means missing the opportunity.

That is not necessarily true.

If a company eventually becomes an exceptional business and remains successful for decades, there may be many opportunities to become a shareholder.

Waiting several quarters can allow investors to evaluate earnings reports, management execution, profitability trends, competitive developments, and stock behavior as the initial IPO excitement fades.

You may pay a higher price if the company performs exceptionally well. You may also avoid paying an inflated price for a company that fails to meet expectations.

You do not have to catch the first dollar of a company's growth to participate in its long-term success.

Consider the Role of the Investment in Your Portfolio

Even when an IPO appears attractive, investors should consider how it fits within their overall financial plan.

Allocating a large percentage of a portfolio to a single newly public company creates concentration risk. If the company struggles, the consequences can be significantly greater than if the position represented only a small portion of a diversified portfolio.

An investor may believe strongly in a company's future while still limiting the size of the investment.

Diversification does not eliminate investment losses, but it can reduce the impact of a single company's failure on the overall portfolio.

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The Bottom Line

IPOs can be exciting, but excitement should not replace investment discipline.

For long-term investors, the objective should not simply be to identify the next stock that could rise quickly after going public. The objective is to identify high-quality businesses that can create value over many years—and purchase them at prices that appropriately reflect their risks and prospects.

Sometimes that opportunity may exist at the IPO. Other times, the better decision may be to watch, research, and wait. A disciplined long-term investor understands that missing a short-term rally is not necessarily a mistake. Buying an investment without understanding the company, valuation, and risks can be a mistake.

Before investing in an IPO, ask yourself three questions:

Do I understand the business?

Do I believe the valuation is reasonable?

Would I be comfortable owning this investment for the next 5–10 years if the stock experienced a significant decline along the way?

If the answer to any of those questions is no, patience may be the better investment decision.

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Collins Wealth Management LLC is a Fee-only, fiduciary Registered Investment Advisor firm. The information herein is intended for educational purposes only and is not exhaustive. Diversification, or any strategy that may be discussed, does not guarantee against investment losses but is intended to help manage risk and return. If applicable, historical discussions or opinions are not predictive of future events. The content is presented in good faith and has been drawn from sources believed to be reliable. The content is not intended to be legal, tax, or financial advice. Please consult a legal, tax, or financial professional for information specific to your situation.