IPO Pricing Phenomena: Empirical Evidence Of Behavioral Biases

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Michael Adams
Barry Thornton
George Hall



Does IPO stand for Instant Profit Opportunity or It’s Probably Over-priced?  The conundrum is that both answers are generally correct.  The answer appears to depend on the investor’s investment horizon.  This realization provides an enigma for the Efficient Market Hypothesis (EMH) proponents. It is widely known that initial public offering (IPO) stocks in the past have typically been underpriced, thereby allowing the fortunate purchaser to buy the shares in the primary market and systematically beat the stock market averages. This phenomenon is evidenced by the average one-day returns on IPOs of 15% and presents a puzzle to efficient market advocates. Behavioral finance posits that the same underpriced IPO stocks will under-perform the market and deliver substandard performance during the ensuing one to three years. At a minimum, the “new-issues puzzle” presents a challenge to the EMH and has given rise to many class-action stockholder lawsuits alleging illegal price manipulation.   Why under-pricing systematically happens and why issuing firms/major shareholders choose to leave copious amounts of money on the table is not well explained by traditional financial theory.  Behavioral finance melds together investor psychology and normative financial theory in an attempt to explain this market enigma.


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