Wine Is Not Liquid — An Introduction to "Alternative Assets"

By John Arnopp
Analyst, mPower

"Classic" Assets

Learn more about other asset classes! Large-cap Small-and mid-cap International Developed Market Emerging Market General International Stable Value

An asset, as defined by Webster's New World Dictionary, is "anything owned that has exchange value." The importance of holding many different types of assets has been drilled into investors for many years now, as cries of "diversification!" and "asset allocation!" have been heard from most every corner.

There's a good reason for this: asset allocation is the key to an "efficient portfolio" (a collection of assets that yields the highest return for a given level of risk). In almost all cases, the more diversified a portfolio is, the more efficient it will be, so that for every unit of return, less risk is being taken. You can hold a less efficient portfolio, but you will not be compensated for the additional risk -- the return may be the same, but the value of the inefficient portfolio will fluctuate more, with a greater potential for loss.

The basic asset classes that most of us are familiar with include cash, bonds, large-cap stocks, small-cap stocks, and international stocks. When putting together portfolios, most people are primarily concerned with stocks and bonds, usually through the use of mutual funds. To create better portfolios, these broad classes of investment are further broken down into small-, mid-, and large-cap (for equities) and short-, medium-, and long-term (for fixed income investments). Additionally, assets can be classified as domestic, international, or emerging-market.

Is that all there is?

If we considered just those asset classes listed above, we would still be missing an important piece of the available asset pie. These non-traditional, or "alternative," assets include real estate, art, antiques, precious metals, and other collectibles such as wine and, yes, even beanie babies. While there is some amount of real estate securitized in the form of REITs (real estate investment trusts), the value of all hard U.S. real estate is roughly equal to the value of all the equities in the world. Clearly, this is something to examine in more detail.

Christie's, Sotheby's and eBay

If you invest in someone else's house, or in an expensive bottle of wine for which you don't know the storage conditions, or a "retired" beanie baby bought sight unseen through eBay, you are likely to get burned. In fact, you are more likely to make a poor investment than you would be if you simply bought a publicly traded stock - any stock - at random. This is due to two main factors.

First, there are costs associated with investment transactions. In the case of the public stock, there is the price, which includes a risk premium. The total price reflects the demand and availability of the stock (the bid/ask spread), as well as the commissions required to execute the transaction. The risk premium aspect of the price reflects the uncertainty of the returns (cash flow--such as dividend payments--or some other measure of future value) for the stock. These are well-defined for a stock, as the market is fairly efficient at pricing public securities, and the risk premium for various asset classes is usually known, based on inflation and the risk-free rate (usually defined as the rate paid by U.S. Treasury Bills).

Second, there is a liquidity factor. Most publicly traded stocks are fairly "liquid," meaning that many shares change hands during trading hours every day, with prices more or less continuous based on available information. At any given time and at any given price, there are numerous sellers and buyers willing to exchange shares. However, for rarer items that are not well-researched, or for which there are no direct comparisons ("every property is unique"), there is not much liquidity, since each transaction is unique and subject to many factors. How would you value a single Rembrandt painting? A bottle of vintage wine? Two bottles of wine of the same variety and vintage, produced by the same winery, may have been stored differently, or there simply may be no information on the storage of one of the bottles. What is the risk that the wine will have gone bad? This asset does not produce any cash flow, so other valuation techniques are required - namely, the opinion of the recognized expert.

If you have, or can obtain, expertise in a specific area, then you may be able to perform very well in these types of illiquid markets. Alternatively, if you need a place to live and the appreciation of a residence is secondary to your needs, treading into these murky waters can also pay off. Lacking expertise, the other way to gain by investing in alternative assets is to buy a completely diversified portfolio of non-traditional assets. However, this is generally only available to those of extreme wealth, and perhaps even not then, given the tremendous costs that would be involved. Either way, you should see increased diversification if you are already holding a diversified portfolio of stocks and bonds.

What About My 401(k) and IRA?

Your 401(k) plan probably does not offer you the opportunity to invest in alternative asset classes, outside of REITS (if even those). 401(k) plans are prohibited from investing in collectibles such as art, and most plans find administering other unconventional assets too cumbersome.

Still, Ted Benna says he has seen some plans with unusual assets, including collectible cars (before collectibles were banned) and company equipment -- even company vending machines. Benna, a benefits consultant who created the first 401(k) plan, says small plans that are funded entirely by the employer would be more likely to include unusual assets. Larger plans that include contributions from employees would tend to prefer investments that can be valued daily and don't require high maintenance.

You might have more flexibility with an IRA, if you can find a custodian who will let you establish what is known as a "self-directed IRA." There are still certain prohibitions, such as those against collectibles (except certain U.S. minted coins) and prohibited self-dealing transactions. The law in this area can get quite complicated, and if you violate IRS rules, you risk losing tax-deferred status.

But, if you are knowledgeable and willing, you may be able to make some interesting investments. However, you should again carefully consider whether you are either "expert" enough in the specific area you are investing or are wealthy enough to purchase adequate diversification.

Summing Up

Stocks and bonds are not the entire sum of possible investments, even in a retirement account. If you have a special expertise or area of interest, you may be able to profit from it by making alternative investments. Almost everyone can do better by adding some alternative investments, such as real estate, to his or her portfolio.

A residence (or a REIT mutual fund) may be all the real estate most people need for adequate diversification. For others, an IRA that holds several apartment buildings may be just the thing. While most people should stick to traditional assets and concentrate on adequate mutual fund portfolio diversification, there are other investments out there that you should at least be aware of, whether or not you take advantage of them.

However, in the final analysis, art will almost always be better hanging on your wall where you can appreciate it, and wine is best as a very short-term liquid asset.

The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.

Wine Is Not Liquid — An Introduction to "Alternative Assets"

By John Arnopp
Analyst, mPower

"Classic" Assets

Learn more about other asset classes! Large-cap Small-and mid-cap International Developed Market Emerging Market General International Stable Value

An asset, as defined by Webster's New World Dictionary, is "anything owned that has exchange value." The importance of holding many different types of assets has been drilled into investors for many years now, as cries of "diversification!" and "asset allocation!" have been heard from most every corner.

There's a good reason for this: asset allocation is the key to an "efficient portfolio" (a collection of assets that yields the highest return for a given level of risk). In almost all cases, the more diversified a portfolio is, the more efficient it will be, so that for every unit of return, less risk is being taken. You can hold a less efficient portfolio, but you will not be compensated for the additional risk -- the return may be the same, but the value of the inefficient portfolio will fluctuate more, with a greater potential for loss.

The basic asset classes that most of us are familiar with include cash, bonds, large-cap stocks, small-cap stocks, and international stocks. When putting together portfolios, most people are primarily concerned with stocks and bonds, usually through the use of mutual funds. To create better portfolios, these broad classes of investment are further broken down into small-, mid-, and large-cap (for equities) and short-, medium-, and long-term (for fixed income investments). Additionally, assets can be classified as domestic, international, or emerging-market.

Is that all there is?

If we considered just those asset classes listed above, we would still be missing an important piece of the available asset pie. These non-traditional, or "alternative," assets include real estate, art, antiques, precious metals, and other collectibles such as wine and, yes, even beanie babies. While there is some amount of real estate securitized in the form of REITs (real estate investment trusts), the value of all hard U.S. real estate is roughly equal to the value of all the equities in the world. Clearly, this is something to examine in more detail.

Christie's, Sotheby's and eBay

If you invest in someone else's house, or in an expensive bottle of wine for which you don't know the storage conditions, or a "retired" beanie baby bought sight unseen through eBay, you are likely to get burned. In fact, you are more likely to make a poor investment than you would be if you simply bought a publicly traded stock - any stock - at random. This is due to two main factors.

First, there are costs associated with investment transactions. In the case of the public stock, there is the price, which includes a risk premium. The total price reflects the demand and availability of the stock (the bid/ask spread), as well as the commissions required to execute the transaction. The risk premium aspect of the price reflects the uncertainty of the returns (cash flow--such as dividend payments--or some other measure of future value) for the stock. These are well-defined for a stock, as the market is fairly efficient at pricing public securities, and the risk premium for various asset classes is usually known, based on inflation and the risk-free rate (usually defined as the rate paid by U.S. Treasury Bills).

Second, there is a liquidity factor. Most publicly traded stocks are fairly "liquid," meaning that many shares change hands during trading hours every day, with prices more or less continuous based on available information. At any given time and at any given price, there are numerous sellers and buyers willing to exchange shares. However, for rarer items that are not well-researched, or for which there are no direct comparisons ("every property is unique"), there is not much liquidity, since each transaction is unique and subject to many factors. How would you value a single Rembrandt painting? A bottle of vintage wine? Two bottles of wine of the same variety and vintage, produced by the same winery, may have been stored differently, or there simply may be no information on the storage of one of the bottles. What is the risk that the wine will have gone bad? This asset does not produce any cash flow, so other valuation techniques are required - namely, the opinion of the recognized expert.

If you have, or can obtain, expertise in a specific area, then you may be able to perform very well in these types of illiquid markets. Alternatively, if you need a place to live and the appreciation of a residence is secondary to your needs, treading into these murky waters can also pay off. Lacking expertise, the other way to gain by investing in alternative assets is to buy a completely diversified portfolio of non-traditional assets. However, this is generally only available to those of extreme wealth, and perhaps even not then, given the tremendous costs that would be involved. Either way, you should see increased diversification if you are already holding a diversified portfolio of stocks and bonds.

What About My 401(k) and IRA?

Your 401(k) plan probably does not offer you the opportunity to invest in alternative asset classes, outside of REITS (if even those). 401(k) plans are prohibited from investing in collectibles such as art, and most plans find administering other unconventional assets too cumbersome.

Still, Ted Benna says he has seen some plans with unusual assets, including collectible cars (before collectibles were banned) and company equipment -- even company vending machines. Benna, a benefits consultant who created the first 401(k) plan, says small plans that are funded entirely by the employer would be more likely to include unusual assets. Larger plans that include contributions from employees would tend to prefer investments that can be valued daily and don't require high maintenance.

You might have more flexibility with an IRA, if you can find a custodian who will let you establish what is known as a "self-directed IRA." There are still certain prohibitions, such as those against collectibles (except certain U.S. minted coins) and prohibited self-dealing transactions. The law in this area can get quite complicated, and if you violate IRS rules, you risk losing tax-deferred status.

But, if you are knowledgeable and willing, you may be able to make some interesting investments. However, you should again carefully consider whether you are either "expert" enough in the specific area you are investing or are wealthy enough to purchase adequate diversification.

Summing Up

Stocks and bonds are not the entire sum of possible investments, even in a retirement account. If you have a special expertise or area of interest, you may be able to profit from it by making alternative investments. Almost everyone can do better by adding some alternative investments, such as real estate, to his or her portfolio.

A residence (or a REIT mutual fund) may be all the real estate most people need for adequate diversification. For others, an IRA that holds several apartment buildings may be just the thing. While most people should stick to traditional assets and concentrate on adequate mutual fund portfolio diversification, there are other investments out there that you should at least be aware of, whether or not you take advantage of them.

However, in the final analysis, art will almost always be better hanging on your wall where you can appreciate it, and wine is best as a very short-term liquid asset.

The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.