What are the chances that we’ll make money investing in Initial Public Offerings (IPOs)?
Not that high, it turns out. As a group, IPO performance tends to lag the market for some time.
An IPO is accompanied by lots of excitement and hype. Expectations are high and buyers are worked up into a fever.
The best result for the promotors is that values are pushed up well beyond any rational assessment. This attracts people who believe by buying early, they can profit from a quick rise during trading.
Then, because the price is so high, it takes time for reality to catch up, and the relationship between earnings and price to reassert itself, which often means that the growth rate slows down for a while.
The problem we face is that the story we hear hugely influences how we think about a sitution.
For example, lets say you are given a description of a person as someone who likes solving puzzles, is good at maths and something of an introvert.
Also, you’re told that the description comes from a list of 30 engineers and 70 lawyers.
What is the probability that the person described is an engineer?
If you’re like most people, you probably think there is good chance that the description is of an engineer.
Most of us, in this situation ignore the base rate – the fact that 70% of the list are lawyers and so that we should start with the expectation that there is a 70% chance of an individual selected from that list at random being a lawyer.
And the reason we ignore the base rate is because of the story – the additional information about the person’s personality – the puzzle solving and maths capability sends us in the wrong direction.
Without that information, we would probably have gone with the probabilities as given to us. The addition of a third piece of information changed how we looked at the situation.
We see this effect happening all the time around us.
When something happens we cling to the first story that claims to explain what is happening. This bias is exploited by viral fake news stories.
The challenge these days is that we have so much information and so many stories around us that it’s virtually impossible to have an informed view.
Instead of watching the news, it may be a better idea to study history before handing over your money.