How to Allocate a Warhol

• Viewpoint
• February 2012

When the annual Art Basel Miami Beach fair opened in December 2011, the still-precarious global economy put no apparent dent in buyers' enthusiasm. If anything, even with $2.5 billion worth of art on display, the problem for many of the fair's more than 260 galleries was a lack of supply. At the closely watched VIP preview, one noted hip-hop artist reportedly paid $71,000 for a Tracey Emin neon wall sculpture that forms the words "I Listen to the Ocean and All I Hear Is You," while a "spot" painting (a series of multicolored polka dots) by British artist Damien Hirst sold for €500,000. The torrid sales pace even prompted "doomsday" economist Nouriel Roubini, famous for predicting the 2008 market meltdown, to tweet ominously from Miami of a possible art bubble.

The fair, considered an important barometer for the $55 billion-a-year¹ global art market, capped a buoyant year in which a comic-strip painting by pop artist Roy Lichtenstein sold at Christie's in New York for $43 million (a record for the artist), and at Christie's in London five telephone bidders pushed up the price for a 1982 hyperrealistic painting of a burning candle by coveted German painter Gerhard Richter to $16.5 million. The Mei Moses World All-Art Index, which tracks repeat auction house price results for major artists, jumped 10.2% in 2011. Although past performance obviously does not necessarily indicate what the future will hold, last year's results continue a stunning turnaround for the index, which had declined 22.7% amid the financial crisis in 2009. According to Bloomberg News, the art world's two major auction houses, Christie's and Sotheby's, sold $1.7 billion worth of contemporary art in 2011, up from $1.2 billion in 2010 and just $480 million in 2009.

The art market's comeback reflects, at least in part, a view among investors and collectors that art can provide a safe haven in unsettled times, says Jeff Rabin, cofounder and principal of Artvest Partners, an independent art advisory firm with a financial focus. After the financial shock of 2008, Rabin says, "many people are looking to art and other tangible assets as a place to put their money as a store of value outside the financial markets. If you look at performance and earnings, many collectors with a portfolio of artworks have historically done extraordinarily well in aggregate over time."

Without question, money is flowing into galleries and auction houses around the world, helping to drive up prices. Freshly minted millionaires from Silicon Valley and the fast-growing BRIC economies of Brazil, Russia, India and China have plunged into the art market, buying up works as a substitute for many other underperforming traditional investments. Meanwhile, experienced collectors who have seen their collections swell in value the past two years may well wonder how to view their collections in the broader context of their investment portfolios.

Indeed, even beyond the headline paydays (the $43 million Lichtenstein sold for just $2 million in 1988, according to Web site Artinfo), a case can be made for art's soundness as a legitimate investment-grade asset class. Over the past decade, almost every art category, from stolid old masters to edgy contemporary, has outperformed equity indexes in the U.S. and Europe, according to the Mei Moses index. And in the course of the past half century, the overall art market has about matched the gains of the stock market.

The Winds of Fashion

Still, broad index-based statistics mask some unique complexities and pitfalls. For starters, the art market depends not on fundamentals such as materials or energy costs but in large measure on the unpredictable winds of fashion, taste and trend. Record-setting sales and sticker shock at art fairs may give the impression that all art and artists inexorably rise in value. But a buzzed-about artist one year can be a has-been the next, and choosing potential winners has nothing to do with financial modeling or asset-class analysis. The same goes for art categories.

Traditional Chinese art (scrolls, screens, ceramics, furniture, etc., from about 1000-1950) climbed 20.6% in 2011, according to the Mei Moses index, but the market for post-war and contemporary art rose only 6.4%. In a year or two, that gap could widen — or reverse itself. "Bubbles come and go," says Mary Hoeveler, a New York-based private art advisor with M.G. Hoeveler, Ltd. "That's not a reason to stay away from the market. The best works by artists accepted in the critical canon have largely maintained or increased in value over the long term. But it is important to understand the art market's dynamics when buying or selling."

Like a bar of gold in a vault or an acre of steadily growing hardwood, a fine painting (properly insured and conserved) that hangs on your wall should in theory grow in price simply by virtue of the passing years. After all, there are only so many iconic works — Monet's Nymphéas (Water Lilies), for example — and as the planet becomes more crowded with millionaires, these exceptional pieces should logically become even more valuable, in much the way the limited supply of gold and finite global acreage devoted to timber can help boost the value of those commodities.

The best works by artists accepted in the critical canon have largely maintained or increased in value over the long term. But it is important to understand the art market's dynamics when buying or selling.

— Mary Hoeveler,
private art advisor

At the same time, the art-as-scarce-resource model can be a slippery one. While Monet or other established masters won't be creating new work, historical periods and styles can go in or out of favor, and each year brings thousands of paintings from newcomers vying for discovery as the next big thing. Unlike gold or timber, which have intrinsic value, newer works of art could prove to be extremely valuable or worth next to nothing, with the outcome depending on many variables collectors can't control.

The art market, moreover, is illiquid, unregulated and nontransparent. The Mei Moses index tracks thousands of artists and works of art, and yet by definition some of these works may have only ever changed hands twice, unlike the millions of shares of stock that are bought and sold every day. In addition, many transactions are often kept private, making fair-value pricing impossible. Subjective factors such as critics' reviews and auction houses' promotional agendas can also influence prices, often unpredictably.

Where Art Fits Among Your Assets

Each of these factors makes it difficult to apply standard financial models to art investments, or to view them in the same context as more traditional asset classes such as equities or bonds. Although a work of art may well give you a sizable return, "it's difficult to depend on art to provide that return," says Christopher J. Wolfe, chief investment officer, Private Banking and Investment Group at Merrill Lynch.

To offer some context about how you can view an art investment, Wolfe cites the Merrill Lynch Wealth Allocation Framework, which divides all your assets into three distinct "buckets" (see "A Framework for Your Art Investment," below): The first includes the more conservative, reliable investments designed to meet such basic goals as wealth preservation and steady growth, while the second includes assets with greater risk and potential to beat the markets. Art fits squarely into a third bucket of aspirational investments that satisfy an aesthetic or personal goal and might (but very well might not) result in a substantial change in your wealth, Wolfe says. "Art has a role if you already have a well-rounded and balanced investment portfolio, and have cash left over." He notes, however, that the idea of using excess cash in no way implies a cavalier approach to the financial side of investing in art. On the contrary: Having a disciplined, structured framework for your art buying can potentially go a long way to make such investments more financially viable even as it makes you a more discerning collector.

Building an Art Portfolio

The best approach to building an art portfolio is to engage an art advisor who has deep knowledge and insight into the market. This is especially important if you are a newcomer and unfamiliar with the territory. When it comes to buying art, the educated collector has the edge. "Knowledge trumps all," says Thea Westreich, another top New York-based art advisor. That means being mindful of the history of art going back centuries and the evolution of art to the current day. It means delving into great art and understanding its greatness, and participating in a conversation about the direction of art and what is moving it forward. From there you can follow your personal interests and develop a connoisseurship and a keen eye for the art you want to collect. "Great art takes time to know with any degree of accuracy," says Westreich. "With careful attention and curiosity, collectors can make acquisitions based both on empirical evidence and their desire to own the work."

The last thing anyone, including the bank, wants is for owners to lose a piece of art. We want them to remain the stewards of the art.

— John Arena,
expert in fine art lending at U.S. Trust

Finding the intersection between what is personally meaningful and what has true value in the eyes of other buyers may be one of the most important aspects — and biggest thrills — of collecting. "We ask a potential collector, 'What is it that you like, and would want to pass on to heirs?'" Rabin explains. While many people gravitate to one or two narrow areas, such as photography or Impressionist painting, an advisor might suggest broadening that perspective in category and medium. The advisor might have you expand to prints and drawings done by the same artist whose paintings you own, or to pieces by a later artist who was inspired by the work. The advisor should also help set and manage expectations for financial performance. As a general rule, stretching a collection and diversifying across artists and periods helps lower the risk that often comes with a more concentrated focus.

Rabin draws an analogy to stocks. If those artists who have already entered the canon, having established their reputations with major shows and retrospectives, can be compared to blue-chip stocks, then emerging contemporary artists just beginning to grab headlines are more akin to growth stocks: riskier, relatively inexpensive, but with a potential high reward, both financially and intellectually. But even collectors wading deeply into the high-stakes contemporary art market may want to include a Willem de Kooning or Joan Mitchell to balance out the beta of their more speculative holdings. The key is to work with your art advisor to find new artists who most fit your tastes, long term goals and risk tolerance.

Art for Liquidity's Sake

However serious you choose to get about art's investment potential, it makes sense to consider pieces already in your personal collection as a working component of your overall wealth, says John Arena, an expert in fine art lending at U.S. Trust. Unlike bonds or dividend stocks, art doesn't produce regular income, but it can produce liquidity — be it to purchase a vacation property or to expand your collection with more art.

The process of art financing starts with a third-party appraiser called in to value the art. Loans can reach 50% or more of the appraised value, with total loans ranging from a few million dollars and up, says Arena. Subsequent annual appraisals assess any shifts in value as the art market fluctuates, and the loan is adjusted accordingly to minimize risk. Because art is so personal, investors may understandably fear losing treasured works to the bank if a loan can't be repaid. "We work very hard to prevent that," Arena says. "The last thing anyone, including the bank, wants is for the owners to lose a piece of art. We want them to remain the stewards of the art."

The idea of stewardship calls up perhaps the most enriching aspect of art investment, as distinct from most other forms of investment. The added satisfaction comes from establishing a collection that takes on an identity of its own, one that resonates with something deep inside you. "With the right guidance, you can enjoy some of the most exciting works in the history of art," Rabin says. "For as long as you have them, they will inspire awe." That's a return on investment that can't even be calculated.

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