There is a certain appeal to new companies or new industries getting listed. We often find ourselves rushing to apply for IPOs while remembering the regret we felt when we saw companies like Adani Wilmar, Vedant Fashions and Uma Exports listing for prices higher than their offer prices. No one wants to miss an opportunity like that.
But if you find yourself applying to an IPO just because everyone else is, you might be making a psychological error called herd mentality. Here, we cover numerous such psychological errors made by IPO investors and some things you should keep in mind before applying to an IPO.
Psychological errors made by IPO investors
- Getting lured by new industries or new companies
Mistaking new things for things that are better or thinking that new things are always good is an error called the appeal to novelty fallacy. New companies going for IPOs may seem attractive due to their growth potential. In some cases, investors may not consider internal and external factors that can dictate a company’s performance as they are blinded by the attractiveness of new companies.
A real-world example of this would be the Dot Com bubble that formed in the US stock market. Back in the ‘90s, the internet itself was new, and investors were drawn to its potential to change the world.
As internet-based startups started going for IPOs, investors rushed to apply. Because of the frenzy surrounding internet-based companies, first-day IPO returns were skyrocketing. According to a study, in 1996, first-day IPO returns averaged about 17%, while in 1999, the first-day IPO returns averaged about 73%. But eventually, many of the internet-based companies that went for an IPO failed to turn a profit and went under in a span of a few years.
- Paying too much attention to new information
When you disregard the conclusions you made based on the original information because new information is presented to you, you are making an error called the base rate fallacy.
Suppose you know that a particular company that is going for an IPO has really bad prospects. Naturally, you won’t be interested in such a company. But, if you apply when its IPO goes live because the shares are being issued at a relative discount, you might be exhibiting base rate fallacy as you are ignoring your initial conclusion. Even if shares of a company are being issued at a discount, if there is a question mark on its survival, it might not be ideal to invest in it, as you might not be able to sell its shares.
- Paying too much attention to the first piece of information
Suppose you come to know that a very profitable company by the name of XYZ is going for an IPO, and you become interested. After a few weeks, you learn that government plans to discourage exports in order to boost domestic consumption. It turns out that XYZ is an export-focused company and will suffer because of the move planned by the government. If you turn a blind eye to the government’s planned move and still apply to this IPO, you might have an anchoring bias.
An anchoring bias refers to the bias displayed by a person who doesn’t change their initial decision in spite of significant information that suggests you should do otherwise.
- Being deceived by appearances
When you make decisions based on appearances, you are said to have a representativeness heuristics bias. Suppose you recently read reports that luxury brands might be making a comeback as income is rising. Now, you hear about a luxury watch company going for an IPO, and if your first instinct is to rush to apply for it, you might be deceived by appearances. Regardless of how attractive an IPO might seem at first, you must research thoroughly before applying.
- Investing because everyone else is investing
When an investor applies to an IPO just because their peers are applying, they might be a victim of herd mentality. Here, the investor might have thoughts like ‘since everyone is investing, it must be safe’ or ‘I don’t want to miss out on an opportunity everyone is pouncing on.’ Investors suffering from herd mentality will result more people applying for the IPO with a higher chance of good returns when the company is listed.
Investors should try not to be misled by high subscription statuses to avoid being a victim of herd mentality.
Some things investors should keep in mind before going for IPOs
Keeping the following points in mind while considering applying to an IPO might help investors dodge some of the psychological mistakes mentioned above and make sound investment decisions:
IPOs come in bull markets
During bull markets, stock prices are typically on the rise and market sentiment is positive. Such conditions can be favourable for newly listed companies. If a company’s stock price keeps falling after being listed, it might become unwanted by investors. There is a lower probability of market sentiments affecting stock prices of newly listed companies during bull markets. This is why most companies will wait until bull markets arrive to get listed. So, during bull markets, investors may wonder which IPOs they should invest in due to the numerous choices available.
However, to make smart IPO investments, you should avoid being drawn to IPOs just because of positive market sentiments.
Understand how the proceeds will be utilised
IPOs are one of the ways in which a company can bring in a significant amount of capital. This capital can be used for various purposes such as organic or inorganic growth, debt repayment or building working capital. Understanding why a company is going for an IPO or how the IPO proceeds will be used is crucial. Ideally, investors should invest through IPOs only if they agree with how the IPO proceeds will be used.
Don’t forget to look at the promoters
Promoters and managers of a company are involved in its everyday operations and are responsible for key decisions that can influence a company’s growth. Knowing the qualifications and experience of the promoters and managers can give investors an idea about the quality of management of the company.
Investors are humans who can have biases and make errors due to the experiences they have and their personalities. But, this does not mean that such errors are inevitable. When you are considering an IPO, understand the risk of investing in a new company, go through the offering documents and in addition, ask yourself the following questions:
- Why is the company going for an IPO?
- What does it plan to do with proceeds from the IPO?
- Why would I want to own a part of the company in question?
Asking these questions should help you understand the motives of the company and your own motives for considering applying to its IPO. This should help identify the psychological errors you might be making.
At WealthDesk, you can find WealthBaskets, combinations of stocks and ETFs built by SEBI registered professionals. Each WealthBasket has a certain investment theme, like investing in bread and butter companies or investing in MNCs.
Whether it is smart to invest in an IPO is subjective. Investors need to understand why a certain company wants to be listed. They must also introspect and understand why they are considering applying to identify psychological errors they might be making.
As there have been companies that have seen a fall in share price after being listed, IPOs may not always be profitable for investors.
When you are considering applying to an IPO, try to understand why a company wants to get listed and what it plans to do with the proceeds and introspect as to why you were considering applying to identify any psychological errors you may be making.
There have been cases where companies have listed for a lot higher than their offer prices. So, investors might think of IPOs as opportunities to make profits quickly. But, one should also note that there have been companies that fell drastically after being listed.