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Don't Buy Big Tech IPOs

Few events generate as much excitement on Wall Street as the initial public offering of a major technology company. Companies like Facebook (ticker: FB), Twitter ( TWTR) and Snap ( SNAP) have products that are innovative and massively popular, and investors can't wait to get a piece of the action.

Unfortunately, buying these big-name tech stocks as soon as they hit the market has generally proven to be a costly mistake.

The pattern has played out over and over again. Most of these tech giants have huge first days on the market thanks to their underwriters. IPO underwriters are big Wall Street banks who sell shares of an IPO stock to institutional investors and large clients prior to the first day of trading. Underwriters want to maximize the amount of money they can raise for the company, but they also typically want to make sure investors are happy with the stock's initial market performance.

[See: The 10 Best Ways to Buy Tech Stocks.]

For example, a team of underwriters led by Morgan Stanley ( MS) and Goldman Sachs Group ( GS) set Snap's IPO price at $17 per share, a price that raised $3.4 billion in funding for the company. When the stock debuted on the New York Stock Exchange in March, the stock closed its first day of trading at $24.48 for a massive 44 percent gain for IPO investors. That's certainly good news for all those institutional investors who got shares at $17, but the average retail investor who was forced to buy shares in the open market didn't get nearly as good of a deal. In fact, Snap's opening price on its first day of trading was $24, so early market buyers enjoyed just a 2 percent gain.

However, since Snap's highly publicized and widely anticipated debut, the stock has slumped. In its first six weeks of trading, Snap is down 18.5 percent from its first day closing price. While it's still in the early innings for long-term Snap investors, history doesn't bode well for the stock's prospects in the next 11 months.

Eight of the 10 largest technology sector IPOs of all time plummeted between 25 percent and 71 percent in the year following their first day of trading. These stocks often have huge first days on the market, then begin a slow drift downward as investor enthusiasm starts to wane. Twitter finished its first day of trading in 2013 up 72.8 percent from its IPO price and down about 0.4 percent from its opening market price. In the next year, the stock declined 10.7 percent.

Alibaba Group Holding ( BABA), the largest technology IPO of all time, finished its first day of trading up 38 percent from its IPO price but up just 1.2 percent from its opening market price. In the year that followed, Alibaba's share price dropped 30 percent.

Facebook stock fell 31.3 percent in its first year of trading, Groupon, ( GRPN) shares declined 85.3 percent in its first year on the market, Fitbit ( FIT) shares dropped 56.8 percent and the list goes on. These aren't tiny micro-cap tech start-up companies that nobody has heard of. All were at least $4 billion companies at the time they went public.

JJ Kinahan, managing director of client advocacy and market structure for TD Ameritrade, says investors simply get too excited about these companies when they first hit the market.

"They know the product so well that they may not be paying attention to the fact that on the back end, the cost of client acquisition or content monetization may mean that the stock price may have a tough time supporting the initial excitement of the product coming to market," Kinahan says.

"The real lesson for investors is to understand the product and then understand how the company makes money with that product so you can make a better assessment of current and future expectations of revenues and expenses."

[Read: 7 of the Best Tech Stocks to Buy in 2017.]

Owen Murray, director of investments at Horizon Advisors, says this market excitement is one of the major reasons his firm does not invest in IPOs. "It has been my experience that tech IPO pricing tends to be much higher than the fundamentals justify," he says.

Instead of investing in IPOs directly, Horizon invests in diversified funds. While the managers of the funds may choose to invest in IPOs, the diversification the funds provide limits investors' risk exposure.

Commonwealth Financial Network chief investment officer Brad McMillan says investors need to consider how companies choose their IPO timing before buying shares of a newly public company.

"If you think about it, any company will wait for the moment when they believe they can get the highest price," McMillan says. "Many times we see buying pressure drive the price higher initially, but this only increases the incentive for existing shareholders to sell -- which can result in price declines after that initial buying surge subsides."

According to Ihor Dusaniwsky, head of research at financial analytics firm S3 Partners, some stock traders seem to be getting wise to the pattern.

[See: 20 Awesome Dividend Stocks for Guaranteed Income.]

"Short interest in SNAP hit $500 million by mid-March and over $800 million in April," Dusaniwsky says. "Traders using fundamental analytics have a hard time justifying lofty price multiples in businesses that have minimal revenues, profits and/or cash flows, and eventually Street-wide buy-side support dries up and short sellers are able to bring the stock back down to more rational levels."

Investors feel a strong urge to get in early on a new tech stock when it first hits the market, but they should consider taking a more patient approach to these potentially volatile stocks. Popular tech stocks are subject to a number of unique conditions following their IPOs that can even drive the share prices of successful companies like Facebook and Alibaba down 30 percent or more in their first year on the market.

If a newly public tech company has a winning long-term business model, it will deliver strong returns for investors for years to come. By waiting until all the hype and short-term market noise dies down before buying, investors can be more certain that they aren't overpaying for a stock simply because it's new and exciting.

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