A successful restaurant rarely opens its doors on the first day with every table filled and every reservation booked for the next six months. Even the best restaurants spend years refining their menu, building a reputation, and proving they deserve a loyal customer base. Investors, however, often expect newly public companies to justify valuations that already assume future success.
It helps illustrate why initial public offerings, or IPOs, have fascinated investors for decades. They offer an opportunity to invest in companies that were previously available only to founders, employees, venture capital firms, and private equity investors. At the same time, they often arrive in the public markets surrounded by considerable optimism, making it difficult to separate the quality of the business from the price investors are being asked to pay.
The recent SpaceX IPO has brought renewed attention to this topic. While every high-profile IPO generates excitement, SpaceX represents something different from the companies that have traditionally gone public. It may also signal that the IPO market itself is changing in ways investors should understand.
Why Companies Go Public
An IPO marks the transition from private ownership to public ownership. Once a company goes public, its shares begin trading on an exchange where anyone can buy or sell them.
Historically, companies pursued an IPO because they had reached a stage where additional capital could accelerate growth. They might need funding to build factories, expand internationally, develop new products, or hire more employees. Public markets historically offered access to far more capital than private investors could typically provide.
Going public also allows founders, employees, and early investors to convert some of the wealth they have accumulated on paper into liquid assets. After building a business, they finally have an opportunity to sell shares through a public market, though they are often required to wait through a lock-up period before doing so.
These companies are frequently still in the middle of their growth story. Some have only recently become profitable, while others continue operating at a loss because management believes reinvesting every available dollar into future expansion will create greater value over time. Investors purchasing shares at the IPO are often paying for what the company might become rather than what it has already achieved, which is an important implication for long-term returns. That has always been one of the paradoxes of IPO investing. By the time individual investors finally have access to the company, much of the discussion has already shifted from whether the business is promising to how much of that promise has already been incorporated into the price.
Why IPOs Have Often Disappointed Investors
The excitement surrounding an IPO can create the impression that investors are getting in early on the next great success story. Academic research has consistently found that IPOs, on average, have underperformed comparable publicly traded companies over the period following their debut. The most widely cited research comes from finance professor Jay Ritter, whose work has documented long-run underperformance among IPOs dating back several decades.
There is no single reason IPOs have historically underperformed, but several forces tend to work in the same direction. Many companies come to market when expectations are already exceptionally high, meaning investors are paying not only for the business that exists today but also for years of anticipated growth that may or may not materialize. At the same time, companies often pursue an IPO because they still have ambitious expansion plans that require significant investment before producing meaningful profits. Layer on investors’ enthusiasm for industries that appear poised to reshape the economy, and valuations can become difficult to justify. Some companies ultimately reach their potential, while many others fall short.
This does not mean investors should avoid every IPO. Rather, it highlights that buying an IPO simply because it represents an innovative company has not historically been a reliable investment strategy.
Why SpaceX Represents Something Different
SpaceX has attracted attention for reasons that extend well beyond its technology. Unlike many companies that previously entered public markets while still developing their business models, SpaceX reached the public markets only after becoming one of the world’s largest and most valuable private companies. Rather than seeking capital to prove its concept, it entered public markets with a valuation that immediately placed it among the world’s corporate giants.
This reflects a broader shift in how successful companies are financed. Over the past two decades, private capital has become far more plentiful. Venture capital firms, private equity funds, sovereign wealth funds, and institutional investors have supplied enormous amounts of financing to private companies. As a result, firms no longer need to enter public markets as early in their development as previous generations of companies did.
Many of today’s largest technology firms have remained private for years longer than companies such as Microsoft, Cisco, or Amazon did during earlier decades. Private funding has allowed them to continue expanding without accepting the reporting requirements and shareholder scrutiny that accompany public ownership. SpaceX may prove to be the first example of a broader trend rather than an isolated event. Companies such as Anthropic, OpenAI, and Stripe could eventually pursue public offerings with valuations measured in hundreds of billions of dollars. If that happens, investors may become accustomed to seeing companies debut as established industry leaders rather than emerging growth stories.
Admiring a Company Is Different from Buying Its Stock
Investors naturally admire successful businesses because they use their products, follow their innovations, and watch their revenues and profits grow over time. Over time, admiration for the company can become intertwined with expectations for the stock, even though those expectations depend on a different question. The issue is not simply whether the business will continue to succeed, but whether today’s stock price already assumes that success.
History remembers companies such as Google, Apple, and NVIDIA because they became extraordinary long-term investments, while the many IPOs that generated similar excitement but failed to meet expectations have largely been forgotten. This is survivorship bias in action.
Even exceptionally successful companies often experience substantial declines after going public because expectations change, competitive landscapes evolve, and growth inevitably slows as businesses mature. Investors who paid very high prices sometimes discover that a wonderful company can still produce disappointing investment returns when future success has already been reflected in the stock price.
Evaluating a stock is no different than purchasing real estate. A beautiful home may be an excellent place to live, but paying $20 million for a house worth $2 million would still represent a poor investment decision. The quality of the asset has not changed, only the price has.
The same principle applies when evaluating IPOs. Investors should spend as much time considering valuation as they spend admiring the underlying business.
How Index Funds Handle New IPOs
The SpaceX IPO also highlights an interesting aspect of passive investing that often goes unnoticed. Investors often speak about “the market” as though it were a single portfolio, but every index is built according to its own methodology. Index providers establish detailed rules governing which companies qualify for inclusion, when newly public companies become eligible, how often the index is updated, and how each company is weighted. Index funds simply follow those published rules. Because those rules differ across index providers, two funds that appear to track the same segment of the market may not own exactly the same companies at the same time.
If you would like to see these mechanics up close, our workshop, How Do Index Funds Work? Behind the Scenes of Index Funds, walks through how index funds are built and maintained, including how they decide which companies to hold and when.
Following the SpaceX IPO, Russell planned to include the company relatively quickly in its indexes, while S&P Dow Jones Indices followed its existing methodology and waited before adding the company. Those differences may sound technical, but they have meaningful implications for how index funds trade.
Funds tracking Russell indexes must purchase SpaceX once it becomes part of the index. Because those purchases are required by the index methodology, active traders sometimes buy shares beforehand in anticipation of increased demand when index funds begin purchasing. At the same time, index funds must sell portions of their existing holdings to create room for the new addition.
None of these transactions necessarily reflect changing views about the company’s long-term prospects. They simply reflect the mechanics of maintaining an index portfolio. The trading costs associated with those adjustments are generally small relative to the overall portfolio, but they are real implementation costs that can influence performance around major index changes. Most of the time, these differences are barely noticeable, but adding a trillion-dollar IPO changes that equation because adding a company of that size requires meaningful adjustments throughout the portfolio.
Passive Investing Still Makes Sense
None of this changes the fundamental case for passive investing. Low-cost diversified index funds remain one of the strongest evidence-based investment approaches available. The lesson is not that investors should abandon indexing. Rather, it is that index construction deserves more attention than it often receives.
Two funds that appear to track the same broad market can produce slightly different returns because their underlying indexes follow different rules. Those differences may arise from how quickly newly public companies are admitted, how frequently portfolios are rebalanced, or how implementation decisions are handled.
During ordinary market environments, those distinctions rarely receive much attention. However, when extraordinarily large companies enter the public markets, those methodological differences become easier to observe.
Passive investing may appear straightforward to investors, but every index reflects a series of design decisions about how the market should be measured and maintained. Those decisions usually have only a modest effect on long-term performance, yet unusually large events such as the SpaceX IPO make the differences easier to see.
Looking Beyond the Headlines
The excitement surrounding high-profile IPOs is understandable. Companies such as SpaceX represent remarkable technological achievements, and investors naturally want to participate in businesses that appear positioned to shape the future. Successful investing, however, has always required looking beyond the headlines. A company’s future prospects, the price investors pay for those prospects, and the role the investment plays within a diversified portfolio all deserve equal attention.
The broader lesson extends well beyond SpaceX. Successful companies deserve admiration, but investors still have to decide whether the price they are paying leaves room for an attractive long-term return. History suggests that enthusiasm surrounding IPOs has often made that distinction more difficult, not less. The same principle applies to passive investing, where understanding how an index is constructed can matter just as much as understanding what it owns.
As companies continue waiting longer to go public, the mechanics of IPO investing and index construction are likely to become increasingly relevant. Understanding those mechanics can help investors avoid being distracted by headlines and stay focused on the principles that have consistently supported long-term investment success.
Want to learn more? Listen to Episode 238 of the Retire With Style Podcast.
