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The Risks of Initial Public Offerings

The idea of initial public offerings (IPOs) is alluring and irresistible to many investors. Companies that go public are often in industries of great interest to investors at the time. IPO companies also tend to sell products that have become household names to investors in a short period of time. These companies turn to IPOs as a way to raise cash to sustain their rapid growth.

But despite their allure, IPOs are highly speculative because they

  • Lack a stock-trading history: It’s impossible to see how the stock has behaved over the years because an IPO isn’t trading yet.

  • Are usually young companies: Smaller and fast-growing companies are often the ones that go public. These companies tend to have limited operating histories, immature management teams, and only a few products or customers.

  • Sell their shares first to large institutional investors: IPOs are usually first sold to large investors such as pension plans and endowments at the offering price. When the stock begins trading, investors are free to bid those shares above or below that offering price.

    Much-anticipated IPOs often attract so much interest from the general public that the shares get driven to unreasonably high levels. Investors who buy in at the height of the mania are often disappointed with their returns.

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