This is the first of a two-part series produced by Betterment, demonstrating the statistical benefit of diversifying a post-IPO single stock position. Make sure to also read Part Two: When Selling IPO Stock, Don't Let Taxes Stand in Your Way.

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The smart thing to do post-IPO is to diversify – after your stock sale qualifies as a long-term capital gain, of course. We take a deep dive into the numbers to show you exactly why it's a losing bet to hold onto a single stock rather than move into a portfolio of diversified assets.

From 'pop' to flop

First let's look at the performance of seven specific IPO stocks over time, since the date they went public, up to three years out. As the baseline, we used the Betterment portfolio at 90% stocks (the highest level we recommend). We pulled data on every U.S. IPO since 2004, but we highlighted these to show a range of possible outcomes. In the graphic below, you can see the value of $100 invested in that stock through time, after the IPO. The grey line represents the performance of a diversified portfolio over the same period. For full disclosure on how we compute historical returns, including those prior to our existence, see here.

Your $100 Invested: Single Stock Versus Diversified Portfolio

The diversified portfolio is a Betterment 90% stock portfolio net of 0.35% per year, our highest fee. Data is through October 31, 2013.

A common trait of IPO stocks is that they are much more volatile (i.e. they experience a larger range of prices), compared to a diversified portfolio. Take Facebook (FB), for example. Since its IPO on May 18, 2012, it has generally underperformed compared to the diversified portfolio, which in contrast grew relatively steadily over the same period. Recently, Facebook has rallied to be worth close to the value of the diversified portfolio. While it’s up for now, the increased volatility makes the future of the investment more uncertain.

Now take a look at another recent IPO stock, Groupon (GRPN). Groupon's collapse is on the far end of the spectrum, dramatically demonstrating the perils of undiversified risk. The overall pattern, if not the scale, is characteristic of the average post-IPO performance in two ways.

First, IPO stocks tend to have a short-lived period where they've performed well relative to the market. Much of this outperformance comes from the 'pop' on the first day.

Second, after a short period of time (say, six months to a year), the median IPO stock begin to systematically perform worse than a diversified portfolio. In this case, after about a year, Groupon was worth about $15 for every $100 invested or a return of -85%. In contrast, a diversified portfolio was worth $112 for every $100 invested or a return of 12%.

So, after a year, Groupon stock had underperformed a diversified portfolio by 97%. This relative performance – or how well the IPO stocks performs, relative to a diversified Betterment portfolio during the same period of time – is what we'll focus on next. We want to answer the question: Where are you more likely to be better off: in your IPO stock or our portfolio?

The larger trend

To get a better idea of the average behavior of IPO stocks, let’s look at a larger sample of stocks.

In the graphic below, you can view the individual relative performance of every IPO stock since 2004, up to three years after launch, compared to the same diversified portfolio over the same period. Values above zero indicate overperformance. Values beneath zero indicate underperformance. The median performance is highlighted in red. As you can see, the median IPO stock systematically underperforms a diversified Betterment portfolio. This effect is stronger the more time passes since the IPO.

Every IPO Since 2004: Relative Performance of Single Stock Versus Diversified Portfolio

Median IPO stock's relative performance

The diversified portfolio is a Betterment 90% stock portfolio net of 0.35% per year, our highest fee. Data is through October 31, 2013.

Time doesn’t help

We may also want to look at how much worse or better an IPO stock may do.  In the following histogram, we see that there are a few stocks which have done incredibly well. However, there is also a substantial number that has underperformed by up to 100%.

As time goes on, the percentage of IPO stocks which are ahead of a diversified portfolio gets smaller and smaller. After three years, 60% of IPO stocks have underperformed. Move the slider to see the distribution at different points in time.

Three Years Out: The Distribution of IPO Stocks Compared to a Diversified Portfolio

The diversified portfolio is a Betterment 90% stock portfolio net of 0.35% per year, our highest fee. Data is through October 31, 2013.

The Bottom Line

The only time the accumulated outperformance of the diversified portfolio does not outweigh the median IPO stock is in the very short term – but beyond that, we hope the smart wealth-builder sees the clear statistical advantage. Taxes are a far less important consideration than one might think and should not deter transition to an optimally diversified portfolio. They are discussed in part two of this series.

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