I’ve Covered Many IPOs for The Motley Fool. Here’s What Most Investors Get Wrong.

Key Points

Investors love initial public offerings (IPO). An IPO is when a private company goes public for the first time, and, in theory, it is the best time to buy shares. However, that’s not always the case. In fact, in many cases, it’s best to avoid IPO stocks. Here’s what most investors get wrong.

What happens at IPO

An IPO is the first time that any outside investor can buy shares of a company’s stock on an open market. Before an IPO, investors usually provide private seed money. These days, there are funds that offer access to private equity, providing retail investors with an early channel to invest in companies before they go public. But in general, an IPO is the first chance to invest in a company.

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However, even the IPO is largely unavailable to individual investors. Most IPO stocks go straight to institutional investors, and they receive their shares before the first day of trading. Once they start trading on a public exchange like the New York Stock Exchange (NYSE) or the Nasdaq, they’re available to anyone with a trading account.

Recently, many high-profile stocks have set aside some IPO shares for retail investors. Trading platforms like Robinhood Markets and SoFi Technologies offer IPO access to members who request shares, but they don’t always get them. Elon Musk, for example, set aside 20% of Space Exploration Technologies (NASDAQ: SPCX) IPO shares for retail investors, according to reports, but the IPO was reportedly oversubscribed by four or five times the shares being sold, and not all requests were granted.

When is the right time to buy?

The problem with many IPOs is that they get hyped up to unreasonable prices. SpaceX, for example, was initially priced at $130 for the IPO, and by the time the markets opened on the first day of trading, it was already touching $150 per share. That was around 100 times trailing 12-month sales, which is an astronomical valuation. (The company isn’t profitable so there isn’t a price-to-earnings ratio.) However, investors were still rushing to get shares, and the stock shot higher out of the gate before falling a few days later. It now sits at about $148, or slightly below its first-day trading price, but it was well below the IPO price for a while, too.

The IPO, or even the first day of trading, isn’t always the right time to buy. In lower-profile IPOs, if you’ve studied the business and believe it’s a good long-term investment, your stock has time to grow before the market catches on. But in high-profile IPOs, enthusiastic investors can sometimes bid up a stock to unreasonable highs out of excitement, setting it up for a fall. It’s usually prudent to wait out that cycle before investing in a great IPO stock.

There’s another reason it could make more sense to wait. IPOs have a lockup period when insiders and early investors can’t sell their shares on the open market. Employees of a private company may have stock options that become valuable when the company goes public, and they are often priced well below the IPO price. To prevent a flood of new shares into the open market that could distort the stock’s price, insiders typically are restricted from selling right away. Usually, the lockup period is 180 days, by which time the stock is expected to settle into a reasonable market price. The stock price often does fall after the lockup period expires, which could be a more auspicious time to buy.

You don’t need to buy right away to maximize your gains

As with the SpaceX IPO, you might be able to get your hands on a stock for even less than the IPO price if you wait for a better entry point. But you don’t need to get in right away to be successful. IPO stocks are often risky, and it could make more sense to wait until it’s on a more solid footing before deciding it’s worth your money. Over time, a great stock will provide value for shareholders who hold for long periods, and it doesn’t matter if they got in right away.

Here are some examples of total returns when a stock was bought after it was already public for a year, and I didn’t only choose the obvious examples:

• Amazon: IPO on May 15, 1997. Gain today from one year later: 69,120%
• Nvidia: IPO Jan. 22, 1999. Gain today from one year later: 613,000%.
• Visa: IPO March 19, 2008. Gain today from one year later: 3,130%.
• Starbucks: IPO June 26, 1992. Gain today from one year later: 18,710%.

These are just a few examples to make the point, but I would also note that if you spot a great stock, you can buy it and enjoy gains at any time.

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Jennifer Saibil has positions in SoFi Technologies. The Motley Fool has positions in and recommends Amazon, Nvidia, Starbucks, and Visa. The Motley Fool has a disclosure policy.