This article also posted at Seeking Alpha.
With Facebook’s much anticipated IPO around the corner, it’s probably a good time to revisit everyone’s favorite topic. No, I am not talking about photo sharing, but rather concentration risk and diversification. In itself, it is not an exciting discussion, but tech IPOs always make it more interesting and, therefore, worth exploring. We all remember that loveable Internet search giant Google, right? The 2004 IPO turned many of its employees into instant millionaires. More recently Groupon, Zynga and LinkedIn fattened a few pocketbooks.
The highflying, attention-grabbing nature of technology IPOs can make them dangerous to participating employees. The main reason is they create instant wealth concentrated entirely in a single position. Granted, there will be many investment-savvy Facebook employees who know how to properly diversify. But most are experts in tech, media, and marketing, not finance. They invest in what they know, and what they know is their own company. This is true of firms that went public long ago. Many employees continue to hold significant amounts of company stock, but are unaware of the excessive risk it creates in portfolios. Some may hold it for sentimental reasons, others for speculation, or fear of realizing capital gains. Whatever the reason, diversifying out of concentrated positions usually makes sense.
To Sell or Not to Sell
So your company goes public, you exercise options, and you now have 50% of your investment portfolio in a single stock. What do you do? Holding the concentrated position is a big gamble. You may get lucky, but in reality the odds are against you. A study published in the Journal of Finance by Jay Ritter, Professor of Finance at the University of Florida, examined the performance of over 7,400 stocks following their IPOs from 1980 to 2009. While short-term performance was positive (an average first day return of 18.1%), longer-term performance was less than ideal. After three years, post-IPO stocks underperformed broader index firms by almost 20%. Granted, this number was pressured by company shutdowns during the tech boom and bust. But the trend in prior years is the same.
Also consider the performance of stock indices in general. By simple math, the majority of underlying companies underperform the broader index. A few do very well and pull up the index return. But from a pure numbers perspective, there is a higher probability your company will under-perform the market.
Read the rest of the article at Seeking Alpha.