By John Wasik
CHICAGO May 11 You may be smitten with the Facebook story and debating whether or not to buy stock when the company goes public. But if you haven't studied the history of IPOs, you may be jumping into the purchase with unrealistic expectations and flawed biases.
While many of those allocated shares early on will likely prosper - or be able to sell quickly at a profit after an immediate run-up - the rest of us might not fare as well.
The company may raise up to $10.6 billion, an amount that would beat the debuts of tech giant Google Inc while giving it a total stock market value that exceeds Amazon.com . Facebook has indicated an initial public offering (IPO) per-share range of $28 to $35, pegging the potential value of the company at $77 billion to $96 billion.
But when an IPO scores big on its first day, data shows that's not a leading indicator as to how it performs in the future.
"With the exception of IPOs from 1999-2000, there is no reliable relation between first-day returns and the subsequent three-year return," says Jay Ritter, a professor of finance at the University of Florida who has been studying IPO results and updates a database on their performance.
Even if Facebook soars immediately to a market cap of $150 billion or more, there are warning signs ahead, says Ritter: "further upside potential is severely limited."
And if Facebook grows significantly over time, like Apple ? Just based on the historical record of IPOs, there are no guarantees.
Looking at three-year buy-and-hold periods, and comparing them to the larger market, IPO investors made a meager market-adjusted total return of 2 percent from 2001-2010, reports Ritter.
Going back even further, the buy-and-holders did much worse with IPOs when compared to the larger market, as measured by the S&P 500 index including dividends and capital gains. They lost almost 32 percent from 1999-2000; dropped 34 percent from 1995-1998; and declined almost 23 percent from 1980-1989. Remember, these were the golden-fleece days of IPOs, which peaked at 675 offerings in 1996. All told, IPO holders lost about 20 percent in market-adjusted returns from 1980 through 2010, Ritter found.
That then brings us into the realm of behavioral economics, an emerging science that examines how irrational and overconfident we can be. We all love a good story - especially about the stocks that we buy. That hard-wired predilection, though, may prevent us from analyzing past history and accepting the reality that many tech stocks are duds down the road (Pets.com ring a bell?).
I asked Prof. Daniel Kahneman, Nobel laureate in economics and author of the classic "Thinking Fast and Slow" about how investors should regard a new stock like Facebook. While he declined to predict how the company will fare, he suggested looking at the histories of previous stock offerings and their competitors.
In his research, Prof. Kahneman, one of the godfathers of behavioral economics, has discovered that not only do investors tend to be overconfident about their investment choices, they make decisions too quickly based on intuition, which is often wrong. We may fixate upon a number - such as a stock price - and "anchor" it in our minds as something that's obtainable, even though it may be unrealistic. Then we may fool ourselves into thinking that we can predict how well a stock or the general market may do. On top of that, most of us are born optimists.
"People don't know the boundaries of their expertise," Kahneman said. "We live in a subjective world and can't separate what we can forecast from what we can't."
To make our decision making even more complicated, a part of our brains Kahneman calls "System One" creates a "coherent" view of an event that suppresses any ambiguities or other interpretations.
In the case of Facebook, the story of a Harvard undergrad creating a tech colossus has a satisfactory sweetness to it. There's no question that Facebook is one of the most-anticipated public offerings in recent memory. With 900 million signed up to the service and growing - I'm an avid user - it's undeniably one of the most powerful and addictive forms of social media on the planet. Founder Mark Zuckerberg may be our era's Alexander Graham Bell.
But what about the competition? Can the company sustain its growth and gain advertising? Skepticism often gets sidetracked when System One is ruling.
Ultimately, though, despite their magical powers, tech stocks are subject to the laws of supply and demand, earnings, competition and ever-fickle market sentiment. If we can look ourselves in the mirror and admit that, then having honest face time with a Facebook purchase may erase some future worry lines.