Whee! There is a sucker born every minute

Picking up on a couple of recent blog posts about "Art as Investment" by Modern Art Obsession and Lisa Hunter Both cite a Merrill Lynch July 17th investment report A simple risk reduction tool: time [pdf] and Linda Sandler's Bloomberg reportage on the topic. Linda Sandler is an astute writer on the economic side of culture and she is the one who concluded "Art is one of the worst ways for investors to try to make money..." not Merrill Lynch. I think she is biased against the idea that art is "just another investment class" which is a position I can appreciate

At the beginning of the Merrill Lynch study titled "A simple risk reduction tool: time" there is an poignant observation "Because attitudes towards asset classes change over time, diversification among a broad range of assets is important. There has never been an instance where the best performing asset class during one decade was the leader during the subsequent decade."

The conclusion the Merrill report makes is that "For most of the asset classes studied, as investors' time horizon lengthens, the probability of losing money in an investment generally decreases." This is the both the focus of the study and its statistical conclusions.

For most asset classes, if you hold a diversified portfolio, time smoothes out the fluctuations in the value of the investment. I would add that the key term here is "diversified", while not specifically stated in the ML study, it makes all the difference in the world. An undiversified portfolio of assets has a much higher real risk, regardless of the asset class.

The Merrill report goes on to state "The exceptions are Commodities, Gold and Art. The probability of losing money in Commodities doesn't significantly change for a one-month time horizon versus a five-year time horizon. For Gold and Art there is very little decline in the probability of losing money for a one-month time horizon versus a 3-year time horizon." Two of these three asset classes are inherently less diversified and as a result will carry more risk, Art is the exception and one will note the risk of negative return is 1/2 of the other two commodities.

They conclude by noting "Commodities, Gold and Art may be more appropriate investments for those who have truly long-term time horizons." Reading between the lines of this statement, one should notice that these asset classes, along with real estate, are what are known as "tangible assets". Over longer periods of time, tangible assets have a the property of maintaining an intrinsic value relative to the currency. In other words, during periods of inflation tangible assets are more likely to rise in value, maintaining a relationship between the value of the currency and the perceived value of the object.

So anyone who closely read the Merrill Lynch study should now understand that all asset classes carry a degree of risk and that the best performing asset class of one decade will not be the best performing asset class in the following decade.

This does not say that art is a bad investment, nor does it say that art is a good investment. It says that at certain periods in time, art will outperform other investments and during others art will underperform other investments. Just like any other investment class, one should not expect the performance to be linear but will that it will fluctuate in response to investor perceptions and interest.

Some observations on my part:

For the last three or four years, the art speculators have been using the advantage of a frothy artmarket to flip or sell artworks they bought earlier at lower prices.

The dot com bubble of the Gay Nineties is a good illustration of how gullible the public can be. In the financial world when the "smart money" is selling to the "dumb money" it is called "distribution". It is no different in the art market, PT didn't say it but "There is a sucker born every minute" and the "smart money" does use the term "dumb money"

So, I think the party is over.

The 2006 season will be seen as the top of the speculative art bubble. Frankly, I cannot see why anyone would be surprised about this, art professionals have been suggesting that the market could not continue in the manner it has indefinitely.

I do not think that the art market will crash necessarily contract too severely but a little consolidation is probably in order. One of the major structural affects of a bubble mentality is that pricing becomes disconnected from "intrinsic values" and attached to "emotional values" which are primarily projections into the future. A more subtle structural affect is that pricing across the board becomes distorted because it tends to realign itself with the highly visible speculative pricing trends.

Speculative bubbles rely on the greater fool theory, this assumes that since the price is going up, a greater fool will be there to buy from you. Anyone who has traded a fast moving overpriced stock will have an appreciation of how difficult it is to predict exactly when the turn will come or who is the last fool. However, once it becomes clear that the turn is in, the psychology changes and the buyers become a little more cautious.

Another understandable parallel would be the recent peak in the real estate markets. Nine months ago, a newly listed property might elicit a bidding competition among prospective buyers with all the bids coming in above the asking price. Today this is no longer the case, the buyers feel less pressure to chase after the market. Does this mean the real estate market is collapsing? Not at all, but it has slowed down and become more orderly.

This is exactly what I would expect to begin occurring in the art market, over the next year it should become more orderly. A more orderly market means a true collector has a better chance of access to quality artwork because with less chum in the water the sharks tend to go away. If the art market contracts, I suppose some people will complain but I think it would be healthy and better in the longer term. We'll see.