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
"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
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,
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
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
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
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.