Investing

In our more sanguine moments many of us like to imagine that society has unwritten economic rules.  For example, many people believe that acquiring a college bachelor’s degree is a surefire way to secure a position in the coveted middle class.  And perhaps once, long ago, it was even true.  Now however, a college bachelor’s degree is just as likely to trap the young and naïve in a quagmire of six figure student loan debt and minimum wage work.  These unwritten economic rules – otherwise known as conventional wisdom – all too often become a graveyard for the unwary.

Conventional wisdom feels intuitively safe.  It lulls us into not really examining the decisions we’re about to make.  The fact that 100 million other people are making exactly the same decision gives us a sense of invulnerability.  We’re running with the pack now; how could so many people possibly be wrong simultaneously?  And nowhere is this herding dynamic more prevalent than in investing.

Many years ago, I worked in Boston at a medium-sized mutual fund firm.  It was the spring of 2000 near the peak of the dotcom bubble and I was shooting the breeze with a work colleague named Ryan.  He was of Irish descent and had all the vices of any good Irishman: he liked to drink, smoke, gamble and fight.  Our conversation went something like this:

“So Ryan, have you seen how much the NASDAQ is off its recent highs?” I remarked off-handedly.

“It’s a great time to get in,” shot back Ryan giddily as he took a big swig from his morning coffee.  “All that volatility means there are a lot of screaming bargains out there in techland!”

“I’m not sure I’d want to own many of those businesses,” I countered cautiously.  “Some of those big tech companies don’t have any earnings while others have insanely high price-to-earnings ratios.”

“Look, it doesn’t matter which of them you buy.  They’re all going to do great,” admonished Ryan in an exasperated tone as he rolled his eyes.  “The important thing is to get your money in the game!”

Neither of us knew it at the time, but the NASDAQ had actually peaked a month before.  It would go on to lose over 75% of its value over the next few years.  Speculator darlings such as Pets.com, Webvan and Global Crossing all ended up filing bankruptcy in the ensuing chaos.  “Getting in the game,” as Ryan advocated ended up being hazardous to your wealth.

Years later, in late 2005, I had another, eerily similar discussion with a different co-worker named Dave.  By this time I worked at the mutual fund division of a large bank.  The topic revolved around the high price of housing in the Boston area:

“With real estate prices as high as they are I don’t think I’ll every buy a house as long as I live in Boston,” I commented with disappointed resignation.

“What?  Why wouldn’t you buy?” asked Dave incredulously.

“Because renting is cheaper,” I countered, “a lot cheaper.”

“It doesn’t matter how expensive houses are,” intoned Dave earnestly.  “You have to buy in order to get on the escalator up!”

“The escalator up?” I repeated very slowly in utter disbelief.

“Yes, the escalator up!” chirped Dave with obvious excitement.  “You need to own a house in order to get all those fat capital gains!”

Predictably, this conversation with my real-estate obsessed co-worker coincided almost perfectly with the peak of housing prices in the Boston area.  A couple years later the largest financial crisis since the Great Depression descended, driven primarily by the unwinding of a massive housing bubble.  Dave discovered, rather painfully, that escalators can go down as well as up.

Although both of my former co-workers were spectacularly wrong, their beliefs represented the very best conventional wisdom at the time.  The problem is that today’s conventional wisdom all too often becomes tomorrow’s discredited idea.  This is one of the reasons I like art and antiques as investments; they are about as far from conventional wisdom as one can get at the moment.  I don’t have any co-workers telling me I need to sink my 401-k into medieval European illuminated manuscripts or old mine cut diamonds.  There aren’t any radio, television or internet advertisements screaming that I need to buy ancient Roman Republic denarii or vintage mid-century fountain pens.  Few people even know art and antiques can be investments, and that’s the way I like it.

Here is a thought experiment.  What happens to the art and antiques market when they are finally discovered by the broader investment community?  As an example, let’s assume you can currently accumulate Venetian ducats (a high-denomination trade coin struck in gold by medieval Venice) for anywhere from $500 to $600 per coin.  Then one fine day a single pioneering hedge fund starts buying up the coins.

The immediate consequence is that Venetian ducats will disappear from the market almost immediately.  Unless the acquiring hedge fund is both incredibly discreet and sensitive to the realities of the fine art market – a possibility I find most unlikely – my best guess is that the Venetian ducat market will have been picked clean within a couple weeks.  At first, no new supply will appear.  Then, very slowly, a trickle of new pieces will come to market.  Only the pricing won’t be $500 to $600 for each coin.  Instead new sellers will test the market with pricing of perhaps $1,000 to $1,200 each.  The acquisitive hedge fund won’t think anything of paying twice the price for these medieval numismatic works of art.  After all, they were sorely underpriced at their original valuation of $500 or $600 a coin!

So our theoretical hedge fund will keep buying and, predictably, the new sources of supply available at the higher prices will gradually become exhausted over the period of maybe a month.  Then a new tier of supply will trickle into the market, except this time asking $1,500 to $1,800 per coin.  Our nameless hedge fund may hesitate at this point, allowing this new supply to sit largely unpurchased at its new higher price for a time.  But by now the original hedge fund’s ruthless competitors will have shrewdly divined its exotic asset accumulation plans and quickly follow suit.  Therefore, our latest tier of supply will disappear almost instantaneously and prices will rise stunningly fast – first to $2,000, then to $2,400 and finally to $2,800 per coin – all in a matter of weeks.  Finally, as buyers become satiated, prices will drift down over the next few months from their recent highs to stabilize at maybe $2,500 a coin.

And there is our hypothetical situation if traditional asset managers get even peripherally involved in the art market.  Venetian ducat prices skyrocket from $600 to $2,500 a coin – an increase by at least a factor of four – within about 6 short months.  Under this scenario there would be precious little possibility of accumulating new pieces during the market turmoil.  You will most likely either be in at the low starting prices, or on the outside looking in once the fireworks start.

I also assume that it is only a handful of niche hedge funds throwing only a few million dollars at this particular segment of the market.  If large pension funds, endowments, exchange traded funds or mutual funds became buyers, then all my predictions go out the window as they have tens of millions or even hundreds of millions to potentially allocate!  It is also important to keep in mind that if a part of the hedge fund community decides to accumulate Venetian gold ducats as an investment, they would undoubtedly be purchasing other fine art and antiques too.  Thus we would probably see sudden scarcity and rapidly rising prices across several market areas simultaneously.