Emotional versus financial motivations
Markets for art and other treasure assets, although tiny compared with traditional asset classes, are growing. According to Skate’s Art Investment Handbook, there are works by 300,000 artists, valued in total at USD$400 billion, available to trade at any time on the global art market; this results in a trading volume of USD$60 billion per year (although to put that into perspective, weekly trading volumes for all stocks in the Russell 1000 during April 2012 were USD$640 billion)9. Investing in art, once the preserve of a wealthy elite in Europe and North America, is now global. In 2010, China overtook the United States as the world’s largest art market for the first time10.
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Many advisers argue that investing in treasure assets, such as art, helps to diversify portfolios, protects against inflation and currency devaluation, and provides returns that are uncorrelated with those in the main financial asset classes. On average, only 18% of the treasure owned by wealthy individuals in our survey is owned purely as an investment and just 21% to provide financial security if conventional investments fail; although, it should be noted that there will be overlap between these motivations.
Analysis of specific categories of treasure shows that this result is skewed somewhat by precious metals, which are arguably more commodity-like in their characteristics. Nearly 60% of respondents say they own precious metals for pure investment motivations, while 10% of them said they hold fine art, antique furniture or wine for the same reason (see chart 11). The pattern is similar when respondents are asked whether they hold different assets to provide financial security should other investments fail (see chart 12).
Financial motivations for holding treasure can encompass a range of different underlying preferences. Mr Salmon argues that individuals who buy treasure for financial reasons do not always do so in the anticipation that the item will provide a financial return. “People do not generally buy treasure because it is going to rise in value,” he explains. “They do so because it has a permanent value of some description. That is a much more sensible and realistic motive than buying something because you expect to make a profit from it.”
There are significant regional differences in the propensity of wealthy individuals to hold treasure for financial reasons. Respondents from India and Qatar hold a substantial portion of their treasure, in part, for financial motivations (67% and 50% respectively), while respondents in the U.S. and Switzerland hold less than 10% of their treasure assets for financial reasons (see chart 13).
Again, it seems that respondents from countries with large amounts of new wealth, where there is high inflation, or where financial markets may be less developed and more volatile, have a preference for holding at least part of their wealth in treasure as a store of financial value. It is striking to note, for example, that 98% of respondents from Qatar and 90% from India agree that it is hard to find things that will remain secure in terms of financial value (see chart 13).
But is holding treasure really a good investment? Some investors will, of course, do extremely well even if most do not earn good risk-adjusted returns. By one measure, returns from investing in art can outpace stock markets. The Mei Moses All Art Index11, which tracks returns from paintings sold mainly in New York and London, returned 11% in 2011, beating the return from the S&P 500 by about 9%; although, of course, an example of a single year with specific selected indices in no way proves a more general point.
Many observers also point to problems with indices like Mei Moses, which inherently cover a tiny proportion of the art market, and only those sales that took place at auction, rather than the far larger proportion that are transacted privately or through dealers. There is also a selection bias, because works that come up in auction will typically be those that are likely to sell.
“Indices do not include work that auction houses have refused to accept for resale,” says Don Thompson, Professor at the Schulich School of Business, York University, Toronto; Contributing Editor to The Art Economist; and Author of The $12 Million Stuffed Shark: The Curious Economics of Contemporary Art. “Art that has not found success in past sales no longer appears in prestigious evening auctions. Only successful artists — those with rising sales prices at auction — have their work appear in the index. This is analogous to looking only at S&P 500 stocks that have increased in value, and concluding that investment in shares is a good thing.”
There is also limited evidence that treasure assets are uncorrelated with broader financial markets. When the financial crisis first struck in 2008, the prices of many collectibles dropped significantly. Then, as financial markets recovered in 2010, the art market also rebounded. In a comparison between art prices and the performance of the London Stock Exchange going back to 1765, the academic William Goetzmann found a strong positive relation between the movements of both12.
The types of individuals who acquire treasure tend to be people like entrepreneurs and professional financial workers, whose large incomes and wealth fall when broader financial markets suffer (see chart 14). “Demand for treasure is driven by investors with large incomes, and that is heavily cyclical,” says Dr Davies.
In addition to being correlated with financial markets, investing in treasure is highly risky. Consider the art world as an example. Although media reports tend to focus on the blockbuster auctions where everything massively exceeded its reserve, there are many items that fail to sell and many that auction houses will not be prepared to put forward at all.
Art is typically an illiquid investment, which means that sellers cannot always offload it in times of need. “The first time you try to sell a painting, you suddenly realise how ill-equipped the market is and how huge the bid-offer spreads are,” says Mr Salmon. “It’s much harder to sell art than people think and just because something is valued at a certain amount doesn’t mean that you can expect anything approaching that if it is sold.”
This does vary from one category of treasure to another, however. Chris Smith, an Investment Manager for the Wine Investment Fund, points out that wine is easier to value and sell than, say, art, because many bottles of wine are made at a single chateau each year, whereas every painting is unique. Even within wine, however, there are differences. “If you’re looking for liquidity, it’s better to invest in Bordeaux than Burgundy, simply because the quantities are larger,” explains Mr Smith.
Valuation is another key challenge, despite the emergence of indices for some types of treasure and an increase in publically available price information. In the art world, trading volumes are extremely thin, which makes it very difficult to arrive at an objective valuation. The length of time that elapses between a single work coming for auction for a second time can be enormous. Research by Clare McAndrew, founder of Arts Economics, a consulting firm, found that it takes on average about 30 years for the same work of art to appear on the market again13.
The prices achieved at auction for similar works can vary enormously, and be influenced by a range of factors, including the skill of the auctioneer, the interaction between bidders and the sale price of previous lots. Even the weather on the day can make a difference. Professor Pownall has conducted research that compares repeat sales in the London market with the weather on the days when auctions took place14. “We found that, on exceptionally sunny days, people were willing to pay more,” she explains.
The transaction costs associated with investing in treasure can be high, and many investors omit to factor these into their overall financial planning. At major auction houses, buyers can expect to pay up to 25% on the value of purchases, although the premium on sales falls as final bids increase. Buyers also need to take into account sales taxes — which will vary depending on where the purchase is made — import taxes, transport costs and brokerage fees — which could cost around 10% of the purchase price.
There are also ongoing costs to consider, including insurance, storage and maintenance. Property and casualty insurance will cost between USD$700 and USD$1,000 per USD$1 million of appraised value15. Certain pieces may require storage in climate-controlled units with consistent temperature and humidity. In total, the annual costs of managing a collection are typically between 1% and 5% of the value of the works16. A rise in the collection’s value over time increases this burden, because the annual costs grow in absolute terms.
Although investing in art and other treasures is often cited as an effective means of diversifying a portfolio, simply holding a proportion of wealth in art, for example, is not enough even if that were the case. Investors must also diversify within a single category, because the sub-categories can have very different dynamics, risks and returns. Contemporary Chinese art, for example, will behave very differently from the market for Old Masters. Diversifying properly therefore requires very deep pockets, because of the need to hold a variety of items with different characteristics.
Funds can offer collectors who are motivated by financial goals a way of achieving that diversification17 without owning multiple categories outright. “People have seen the growth and value of art, and they want to have a stake in it but can’t access it on their own,” says Mr Hoffman of the Fine Art Fund. “We’ve got 45 people on our team and we cover twelve different sectors of the art market. If you know what you’re doing in the art market, you can buy privately and you can often get a big discount for being a cash buyer. You can then sell at auction or at retail and the margins can be enormous.”
Finally, there can be problems with authenticity. In 2011, the Knoedler Gallery closed after a controversy involving a painting purported to be by Jackson Pollock but now believed to be a forgery. Some scholars have been reluctant to authenticate works because they fear lawsuits should they make the wrong call. If a scholar who specialises in an artist’s work says that a painting is not authentic, they run the risk of a lawsuit brought by the seller. With most scholars offering their opinions for free or at minimal cost, there is therefore little incentive for them to make pronouncements on a work that could later prove controversial.
Of course, investors may also benefit from these inefficiencies in the art market. Many individuals can and do make large sums of money from investing in art and other treasure assets. The relatively small size of the art market means that there are more opportunities to create and move markets than in, say, equities or currencies. Even something as simple as exhibiting a work can enhance its value. “There are some people who have started collecting and single-handedly created a market,” says Dr Stephen Satchell, Fellow of Trinity College at Cambridge University. “That’s not done necessarily by just shrewdness, but by enthusiasm too and because they’ve been smart enough to collect something that’s popular.”
But creating consistently positive returns requires a high degree of expertise, time and contacts, which very few casual collectors will possess. Funds can be one way of accessing this expertise but, as with funds in traditional financial markets, finding the right ones can be challenging. “To be a successful art fund you need size, expertise, track record and the ability to source art privately,” says Mr Hoffman. “If you haven’t got those it will be extremely difficult.”
When an individual invests in any financial asset — whether a stock, bond or real estate fund — their reasons for doing so will typically combine both financial and emotional motivations. As well as thinking about the potential financial returns from investing in a hedge fund, for example, an individual may also derive a benefit from the status that being a sophisticated investor brings, while an investor in bonds may derive comfort from their perceived safety.
Treasure investments are no different. Although some individuals may acquire treasure primarily for financial reasons, a greater proportion of the benefits can be derived from the emotional aspects, such as enjoyment, status, sharing with friends or bequeathing to dependents. “When somebody buys a painting for USD$80 million, the utilitarian value of that painting is no greater than that of a poster that sells for USD$20,” says Meir Statman, Glenn Klimek Professor of Finance at the Leavey School of Business, Santa Clara University and Author of What Investors Really Want. “This means that most of the benefits come from the expressive and emotional aspects.”
The fact that treasure has such a large emotional component to it means that collectors can be particularly susceptible to behavioural biases and heuristics. “We know that traditional investments suffer from behavioural biases but, in the art market where there’s a greater amount of emotional value involved, then these biases are by definition more severe,” says Professor Pownall. “Investors are more averse to making losses and tend to want to hold onto winners for a longer period of time in the art market than with traditional investments.”
The availability bias, a mental shortcut whereby investors will draw conclusions from information and examples that are readily at hand, can skew decision making. Because media reports on art sales tend to focus on the spectacular gains and the record-breaking hammer prices, investors may falsely believe that these are representative of broader trends in the market. “Stories about those spectacular gains give investors a false sense of security that the average return on art is very high because those cases are the most available in their memory,” explains Professor Statman.
In a public auction, bidders may become susceptible to the winner’s curse, which holds that the winner of the auction will be the one that has been most optimistic in their appraisal of an item’s value, and therefore almost by definition will overpay. Emotional attachment to an object can exacerbate this phenomenon, causing the affect bias. “People will tend to pay more and consider a purchase to be less risky if they like an object and they’ll also pay more if they are in a good mood,” says Professor Pownall.
The previous price paid for a similar item can also have an impact on price expectations in a bias known as anchoring. Academic research has shown, for example, that buyers in an auction will “anchor” their estimate of the value of an artwork on the previous sale18. But this can create distortions because the previous sale may have taken place in a “hot” market, when valuations were unusually high, or in a “cold” market, when they were uncharacteristically low. Bidders can also anchor their valuation to the estimate given by the auction house at the time of sale.
Treasure can be susceptible to some strange inversions of traditional economic theory. With most consumption goods, increased scarcity leads to higher prices but with art, the opposite sometimes seems to be true. It is striking that, of the artists that achieve the highest prices at auction, many are highly prolific. Damien Hirst and Andy Warhol, for example, have produced countless artworks yet, rather than reduce prices, their familiarity and exposure have helped to raise them. “The mere fact that a collectible is highly priced will induce demand from some buyers,” says Mr Salmon. “When you buy a Damien Hirst or an Andy Warhol, they are instantly recognisable and people know them first and foremost for being expensive.”
Some collectors will ascribe different motivations for their investment depending on its performance over time. For example, if the value of an item increases, they are more likely to ascribe this to their shrewd financial judgement, but if it falls, they may focus more on the emotional benefits. “According to the attribution bias, people think of assets differently depending on whether they are rising or falling in value,” says Professor Pownall. “If prices are rising, they will be happy to think of collectibles as an investment but, if they are falling, they are more likely to say that they bought something because they like it.”
As good as gold
Throughout history, gold has played a central role in the development of humankind. In the words of economic historian, Peter Bernstein: “Gold has motivated entire societies, torn economies to shreds, determined the fate of kings and emperors, inspired the most beautiful works of art, provoked horrible acts by one people against another, and driven men to endure intense hardship in the hope of finding instant wealth and annihilating uncertainty19.”
Gold has been crucial in the world of finance, initially as a currency, then as a backbone to currencies, through the gold standard and the Bretton Woods system. Today, central banks hold gold as a store of value and as a guarantee to redeem promises to pay depositors. Although some central banks, including the U.K., have sold off gold holdings over the past two decades, many have been buying it again as soaring sovereign debts have undermined the value of the U.S. dollar, the euro and the yen.
Yet as an asset, gold does not pay any direct financial return, whether a dividend, coupon or rent. As Warren Buffett said in a 2012 preview to Berkshire Hathaway’s Annual letter to shareholders20: “It has two significant shortcomings, being neither of much use nor procreative.”
So why do investors hold gold? There is a strong historical association between gold and treasure, and a perception to this day that, if you own gold, then you are both rich and safe. Jonathan Spall, Director of Commodities at the Investment Banking division of Barclays, explains that much of gold’s popularity is due to political uncertainties. “People hold gold because it’s a hedge against uncertainty,” he explains.
Mr Spall believes that owning gold is, in many ways, no different from owning a Rembrandt. “The painting is worthwhile for them because they believe in it, even if other people see it merely as a collection of wood, canvas and paint,” he says. “It’s the same with precious metals like gold. They provide security because people believe in them. Buyers analyse an investment in gold in a very different way from an investment in copper, for example, although both are commodities.”
Since February 2012, better news on the U.S. economy and some much-needed breathing space in the eurozone crisis have caused gold prices to fall slightly. With investors feeling slightly more optimistic about the global economy, what does this mean for gold over the longer term? This may be a difficult question to answer but, whatever happens, gold is unlikely to lose its appeal. As Warren Buffett has said: “When people a century from now are fearful, it’s likely that many will still rush to gold.”8 Diversification does not protect against loss
10 The International Art Market in 2011: Observations on the Art Trade over 25 Years
11 The Mei Moses family of art indexes are based on a proprietary database of repeat sale pairs created from transactions in the art auction markets of the U.S., Europe and China. The database now has a total of over 30,000 repeat sale pairs for approximately 20,000 individual works of art.
12 Art and Money, William Goetzmann, Luc Renneboog and Christophe Spaenjers, April 2010
13 Quoted in CFA Magazine, The Fine Art of Investing, May to June, 2010
14 Does the sun “shine” on art prices?
17 Diversification does not protect against loss.
18 Diversification Anchoring Effects: Evidence from Art Auctions
19 The Power of Gold, Peter Bernstein
20 http://www.berkshirehathaway.com/2011ar/2011ar.pdf [PDF, 487KB]