Fine wine investment: Grasping diversification

It’s quite surprising given how often we talk and write about diversification that as a concept it still seems difficult for some people to grasp, so if you have already mastered this important aspect of investment theory please feel free to skip this note.

Perhaps it reflects how relatively new the idea of investing in fine wine is, because of course if you are a collector or consumer it is fair to say that diversification doesn’t matter a fig.

We are driven to address this subject again by a client fulminating about his investment performance because over the first year of his investment he was “only” beating the index by 20%.

Aside from the fact that in fine wine investment terms a single year is insufficient to make any real judgement – at Amphora we argue for a very minimum term of three years and prefer at least five – there are clear misunderstandings about what we are trying to achieve.

Lest anyone think we are breaking some equivalent of a Hippocratic Oath in discussing this below, please be advised that we have the client’s permission to disclose the exchange.

Let me take two or three observations: “why did you select that wine when a different vintage from the same producer has gone up more?”

It is perfectly possible, indeed quite likely, that over shorter periods of time the wines chosen by the algorithm may not be the very best performers, for the simple reason that the market is inefficient and slow-moving, and in consequence it may take longer for true value to be appreciated. This is absolutely not an issue if the investment time frame is clear, and indeed were the market more efficient there would actually be fewer opportunities of which to take advantage.

The inefficiency is therefore a good thing, although it is fair to say the market won’t dance to anyone’s particular tune.

“The average performance of the whole portfolio has been disproportionately boosted by this wine, so why didn’t I buy more of it.”

Two questions in one here. Firstly, we didn’t recommend buying more of that wine because unfortunately we lack the crystal ball which would have facilitated such a manoeuvre. Secondly, in a diversified portfolio it is unlikely that any constituents will perform in line with the average price movement. There is no reason why they should, and more often than not they don’t.

The reasons for this are that in a dynamic market price moves are quite random and reflect the day to day ebb and flow of interest on the buy and the sell side. This is why charts illustrating price movement seldom describe a straight line, and any point in time you chose as the ‘strike’ is affected by this. In addition an average is only a mathematical calculation reflecting a combination of moves. There is no logical reason for the resulting sum to equate exactly to any of its constituent numbers.

“One of the positions has actually gone down in value.”

Stuff happens. See above. Keep calm, your time will come.

“I could perhaps have done as well throwing darts at a list of wines and buying where the darts landed.”

Possibly, but there would have been no control over the level of risk and of course this borrowed premise is flawed. Back in the 1970s a bestseller hit the shelves called “A Random Walk Down Wall Street” whose contention was that a blindfold monkey throwing darts at the stock-market pages of a newspaper had a good chance of outperforming the experts.

The problem is that this random approach took no account of the market capitalisation of the stocks selected. You would as likely have small caps as blue chips, and although the small caps can outperform they also pose a significantly higher risk.

Now although there are no market capitalisation considerations when choosing wines to invest in, there is a great deal of risk to be considered, all the way from marketability which we discussed recently through to diversification. The expression ‘don’t put all your eggs in one basket’ exists for a reason.

To sum up we suggest very strongly that a lot of the principles associated with investing in global stock markets are applicable to making investments in fine wine. Just as your pension fund will likely contain stocks which underperform the average at certain times, they are there for a reason, and that is because your (hopefully) highly-experienced fund manager thinks they will come good in the end.

You might be surprised at how low the bar seems to be set for targeted pension fund performance, and that is because the risk is set against the reward of your receiving money in your old age. You can make much riskier investments where the rewards are possibly much higher but financial advisers exist to try and make sure that you are aware of the risk and that it is in tune with your financial ambitions.

The beauty of investing in fine wine, to our way of thinking, is that you can engineer higher end returns for lower end risk, by combining awareness of the unique investment dynamics of the fine wine market of diminishing supply and increasing desirability, with tried and tested mainstream market investment techniques and principles.

Philip Staveley is head of research at Amphora Portfolio Management. After a career in the City running emerging markets businesses for such investment banks as Merrill Lynch and Deutsche Bank he now heads up the fine wine investment research proposition with Amphora.