Wealth – a place for art and wine in your portfolio?

Not long ago I was asked by a client about purchasing a valuable musical treasure. What did I think about taking money from her budget to make such a purchase? What role could it play, she wondered, in her investment portfolio? And just last week I was asked by another client how he could include his valuable wine inventory in his portfolio? Interesting questions, indeed, and not just because they have to do with investing, but because they are a reflection of the deep seated desire in all of us to find some way to make our passions work for us.

As an intelligent investor we must first create a base or foundation on which to build wealth before investing current cash flow into such possibilities. If you think of your wealth as forming three tiers, the first tier, or foundation, consists of good credit sources together with a robust combination of liquid assets and emergency funds. With this tier in place, an investor can withstand market volatility, support ongoing needs and endure any unforeseen emergencies for a period of time. The first tier provides the conditions necessary for building the second tier—a diversified equity and bond portfolio.

The purpose of the second tier is to extract as much growth as possible from the market, while providing a safety-net that respects your risk tolerance. The second tier is intended for your future financial security and must therefore not be exposed to excessive risk (at Aikapa, we believe that the best way to counter market risk is through a diversified global portfolio). Once your finances cover these two tiers, then, and only then, can we seriously consider a third (speculative) investment tier that could potentially offer higher returns in exchange for accepting higher risks. These speculative investments could include art,
musical instruments, wine, coins, jewelry, antique firearms or other collectibles for which you may have a passion and an expertise (though not pertinent to this article, this tier can also include other non-collectible investments).

The beauty of this third tier is that it often feeds your creativity and passion, and so should never be discouraged or dismissed, so long as it comes from a position of knowledge and experience. With time and talent it is possible to build a collection that can grow in value over the years. We have a client that has collected stamps since childhood and has therefore a very valuable asset. These investments can be very lucrative when the market is favorable, but a heavy burden when not.

The risk and expense of collectible investing goes beyond the volatility that we’ve seen with wine and the recent upsurge in artworks, with high-profile purchases like the Gaugin that sold for around $300 million.

Collectibles require storage, insurance and maintenance regardless of whether there is even a market to buy them (at times they can be highly illiquid). Accurate valuation is also a challenge, since you must actually attempt to sell any given item to determine its fair market value. The market for collectibles is fickle and historic value is no guarantee. What once sold for a good price, may no longer be in vogue.

If we’re to consider a collectible as part of a portfolio, it must be evaluated for
potential future return. What is often overlooked is the cost of bringing an item to market. In addition to the usual insurance, there can be maintenance costs, special storage facility fees to retain value, and fees associated with proving authenticity. There may also be costs for shipping, installations and appraisals. Selling a collectible often incurs a commission. For artworks, auction house fees can range from 10-25%. Finally, don’t forget that tax liability exists on any gain. For collectibles, the federal tax rate is 28%. There is also state tax and, potentially, a 3.8% net investment income tax for those in
higher tax brackets. We estimate that for most of our California clients they would pay 35-43% of their gain in taxes on collectibles, which often comes as a great shock to the uninitiated.

In a nutshell, speculative investments should never be depended upon to achieve critical goals, such as retirement. While many of our clients include collectibles as part of their wealth (and are generally very passionate and knowledgeable about them), it is only as a component of the third tier of their investment strategy. These collectibles, while often extremely valuable, are never an essential part of a core investment portfolio or retirement plan.

If you’re interested in developing a third tier for your investment portfolio let us know and we’ll work together to provide a financial perspective on your plan. We do not recommend developing this tier from a budget unless tier 1 and 2 are already fully funded.

Edi Alvarez, CFP®