7 Ways Investors Can Cut Risk in a Hot IPO Market

What to watch out for if you jump into the IPO boom shaping up on Wall Street.

Initial Public Offering spelled out on a blackboard
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See what the stock does when it starts trading. During the tech boom, the bad news was that you could not get hot IPO shares if you wanted them. That's not the problem it once was, says Smith. Today, the rise of the private market in pre-IPO shares means you could buy in, but investors might not want to jump in on the first day of trading since those markets can bid up share prices even before they go public, as happened with Facebook. Institutional investors who buy in the open market are "a demanding bunch, very picky," says Smith. They use what they have learned about the IPO company in pre-launch presentations, and they watch who is buying and selling after trading starts. "There is a lot more information after a company starts trading than there is in the very illiquid trading beforehand," says Smith.

Use your IPO fund to diversify. Do IPOs fit into an average investor's portfolio? RDM's Sheldon says, "You do not put all of your eggs in one basket. But it is possible to see it as a diversifier. It's a high-risk and high-volatility sector. That seems to be where it would fit into a portfolio." Smith adds that there is a low correlation between IPOs and the overall market, meaning IPOs offer diversification. IPOs fall more in bear markets, and rise more in bull markets.

Watch for the bubble. Everyone knows the upside. Some stocks roar out of the gate and never look back. The lure of the IPO is the chance to get in early before the investing pack discovers the fast-tracker that eventually becomes the next Cisco. If you bought 100 shares (worth $2,250) in the open market as Cisco started trading in 1990, you would have made more than $2 million in 10 years, according to the company's investor site. (Alas, if you didn't sell in 2000, it's only worth $330,000 now.) But the lure of the golden IPO inevitably leads to frothy investing. The wild successes of the Ciscos and Apples are sometimes followed by waves of overhyped eToys and Webvan offerings that go bust.

This past month was the best in nearly a decade in terms of the volume of new issues and trading gains for stocks going public. So is it time to stand aside and wait for the bubble to pop?

[See: 6 Virtual Currencies That Went Bust.]

"The IPO window has been cracked open [so far this year] – and this month may be wide open," says Hamadeh. The market has not been open to early-stage companies that do not show big revenue growth and clear profit potential. He adds: "Once you see even the small, low-quality companies start to IPO ... that's when you know that we have an IPO bubble."

Coming up on the list of companies going public are two companies that will test the appetite of investors for IPOs. Sprouts Farmers Markets is a profitable and fast-growing organic and farm-grown food chain that sells kangaroo, bison, venison and ostrich meat and is based mostly in the Southwest. Claire's Stores is a familiar retail name in costume jewelry that avoided bankruptcy when it was taken over in a private equity deal. It will go public again soon – and will test whether investors want to swallow a company with more than $2 billion in debt.