Why You Shouldn't Buy Spotify Stock (Right Away)

Why you shouldn't buy Spotify stock -- or at least not right away

Don’t let hype motivate you to make an investment that isn’t perfectly sound — that’s the gist of why you shouldn’t buy Spotify stock on the opening day, which is today (depending on what timezone you’re in when reading this).

The music streaming company Spotify’s stock debut is getting a lot of attention due to it being the largest outfit to go this route instead of doing a traditional initial public offer.

Interestingly, Spotify’s founder and Chief Executive Officer, Daniel Ek, explained in a blog post that Spotify isn’t trying to raise capital through its IPO.

How Spotify’s Direct Sale Compares to an IPO

Even before the debut on the New York Stock Exchange, shares in the company were technically already tradeable by private investors and employees of the company. The company is simply listing its existing shares on the New York Stock Exchange starting tomorrow.

Instead of an opening price, there’s a reference price of $132 — significantly higher than where stocks tend to start out at.

That said, Spotify’s debut on the New York Stock Exchange has things in common with an IPO — athough here a company hires at least one investment bank to begin promoting the shares to the public.

Who Gets First Dibs on the Shares

But what really happens is the investment bank sells first sells to other bankers, institutional investors and high-net worth individuals before the rest of the investing public gets a crack at the stock.

Although the trading doesn’t technically begin until the opening bell rings on the New York Stock Exchange — or the equivalent beginning of session on other exchanges — the investment bankers handling the sale take advance orders for the shares beforehand.

The IPO model limits participation in the first round to the elite — usually the favorite customers of the investment banks — who get to enjoy what often has some of the strongest upside potential of any type of stock transaction.

Spotify, by contrast, is bypassing this convention in order to make the shares immediately available to the broader public. Although a financial institution still does the underwriting — in this case, Citadel Securities is doing it for Spotify — the first buyers of the stock can be anyone with a brokerage account.

Pros and Cons of Direct Sales

The resulting investment opportunity has both pros and cons; rushing into buying the stock right away can have consequences for those who lack the kind of investing experience that typify those who normally participate in IPOs.

Investment banks’ theoretically try to sell initial public offers to sophisticated investors who show an interest in holding on to the stock in order to stabilize it. But in practice the effect looks like it rewards favorites that do the most business with the brokerage

All of this makes Spotify’s direct offering a welcome contrast to those who crave access to the kind of money-making possibilities normally associated with an IPO. The music streaming company’s shares begin trading under the ticker symbol SPOT — and you can get in on the opening via any brokerage where you have an account.

Lots of Risks

Before you rush off to do that, stop and think about the risks. Stock offered directly to the public tends to have more volatility than shares that open through an investment bank. And since the markets are already pretty volatile due to a host of factors, that means Spotify stock could be in for a very bumpy ride indeed.

Speaking of which, Spotify’s choice of an investment bank happens to be an outfit that is known for algorithmic trading, which may be a contributor to market volatilty in addition to being well equipped to navigate those conditions.

The Day(s) After

Related to this — and the reason why investment banks try to take steps to stabilize new stocks: IPOs that have high flying debuts can have a special kind of hangover on the days immediately following. This has happened to stocks of all sizes, including some of the biggest IPOs of all times. It happens so often that Wall Streeters actually have a recurring joke about it.

In fact, the phenomenon may have been part of what Spotify’s CEO was thinking of when he said in his blog post that it’s “the day after, and the following day that matters — and all those days to come. Because that’s when we will continue the hard and important work of our mission.”

In all fairness, many stocks do recover sometime afterward. But that interim period of time can be tough if you’re at all squeamish or have a difficult time tolerating losses. This kind of risk aversion tends to develop among people after they experience a big drawdown in the markets like the 40% average loss during the credit crunch of 2007 to 2009.

Beware Overconcentration

Another risk to beware of: It’s easy to end up overconcentrated or imbalanced if you buy shares direct. A majority of people’s investments today consist of mutual funds or exchange traded funds rather than individual stocks; adding a single stock to such a portfolio may leave you without the correct counterbalances to spread out the risk that you would otherwise incur

Ask a financial planner or broker to help you make sure the rest of your portfolio includes enough diversification to keep you balanced.

Don’t Trade on Emotions

General investing wisdom calls for not basing financial decisions on emotions or impulse — and any motivation to buy Spotify stock that doesn’t consider the fundamentals of the investment might actually have some sentimentality at the root of it.

If you’re fan of Spotify’s services, that doesn’t translate into the shares being a sound addition to your portfolio. Do your research before buying any shares or other type of investment.

Lawsuit Pending

Here comes the kind of risk that shows up in many companies’ investment prospectuses: Spotify has a pending lawsuit against it for $1.6 billion.

Although the suit has not stopped the company from going public, the case continues to incur legal costs that would eat into profits. This would become even more pronounced if the company loses the suit.