Why You Shouldn't Care About IPOs

Since happy and optimistic stock market environments are the most auspicious launching pads for new stocks, it's no surprise that a grisly year like 2008 offered relatively few initial public offerings. But while 2010 looks like it will be far different for the IPO world, that's no reason for Fools to get overly enthusiastic.

Making their debut
A company's initial offering of shares tends to excite investors. Newer, less savvy entrants to the stock market in particular may think that each IPO could be the next Google (NASDAQ:GOOG) -- or the lesser-known Quality Systems (NASDAQ:QSII), which is up an annual average of 43% over the past decade.

According to Hoover's, the number of IPOs roughly doubled to 63 in 2009, from 31 in 2008. Now, less than a month into 2010, there are roughly 100 debuts already scheduled for the year. Companies likely to debut this year include NewEgg.com, while speculation is rampant about Facebook, LinkedIn, and Twitter. Fools, brace yourself to resist the expected hike in IPO activity.

Why should you consider steering clear? For starters, only the well-connected and wealthy generally get access to an IPO's shares right when they hit the market. Those deep-pocketed market moguls have the best chance to reap gains from a stock's initial rise. The rest of us can get in as soon as we can, but history has shown us that newly debuted stocks often settle down in short order, leaving many IPO investors kicking themselves.

Indeed, studies have shown that IPOs are typically underpriced, all but ensuring that they experience a jump upon issue. Researchers Tim Loughran and Jay Ritter found that IPOs in the 1980s rose 7% on their first day, on average. For most of the 1990s, they jumped almost 15%. In the wild-and-crazy 1999-2000 period, they surged an average of 65%. Finally, they settled down (relatively speaking) to 12% leaps between 2001 and 2003. Why set yourself up for such volatility?

Proceed with caution
Most of us would do well to just steer clear of IPOs. If you're just too tempted, though, be sure to stick with established companies, not tiny hopefuls. You might also look into the First Trust U.S. IPO Index (NYSE:FPX) exchange-traded fund, which invests in new and newish IPOs such as these:

Data: Yahoo! Finance.

The fund has outperformed the market, but it has only existed for a few years -- not enough of a track record to earn much faith from Foolish investors.

Don't think you'll miss out on huge gains just because you're wary of IPOs. Look at any list of long-term winners, or even one-year wonders, and you'll see that it's full of companies that have been in the market for a while. When it comes to stocks, youthful energy is often no substitute for experience.

Are IPOs too rich for your blood? Or do you think we've overstated their risks? Make an initial public offering of your comments via the box below.

Editor's note: Contrary to reporting in a previous version of this article, Bird's Eye Foods is not expected to IPO this year. The Fool regrets the error.