We spend a lot of time here at The Motley Fool giving readers the tools, information, and encouragement to help them become better investors. But we don't spend as much time clearly defining what exactly qualifies as an investment.
To me, an investment is best defined as a stake in an enterprise that is expected to grow in value and/or produce cash flow. Buying a share of stock, a government bond, or a piece of a business --whether it's the local coffee bar or a lead mine in New Mexico -- is an investment.
Many collectors and hobbyists mistakenly think of the objects of their desires as "investments." But collectibles such as coins, stamps, or diamonds don't have growth potential, nor do they produce any cash flow of their own.
Compounding your woes
Why does it matter? It's all about the power of time and compounding, my friends.
A 1917 Standing Liberty quarter is going to be more or less the same in 20 years as it is today, but many of today's public companies will likely be significantly different in size and/or scope at the end of that same time period.
Companies' ability to grow from within is a major advantage. Johnson & Johnson (NYSE:JNJ) has grown internally at a double-digit clip for decades, which in turn has powered double-digit compounded annual stock price growth. Compare that with collectibles: On average, they grow in value by about 5% to 7% a year. Even if the stock market grows only about 9% a year in the future, that 2% difference compounds to slightly more than a 20% difference in total return after only a decade.
It's certainly true that stock investing offers no guarantees, but neither do collectibles. What's more, you can almost always sell a listed stock for something close to its quoted price any time you please -- something not always true of collectibles.
Over the long haul, stock performance is reliably linked to earnings and cash flow growth. The valuation of collectibles, though, is based more upon raw supply and demand and the vicissitudes of taste. A Renoir has value because people choose to value it. If you look at the history of price movements in art, coins, and the like, you don't see any sort of reliable correlation -- the price of a Renoir moves independently of the quality of the artist's work. It has more to do with people's taste at a particular point in time.
I believe I can explain why Cisco Systems (NASDAQ:CSCO) is worth more than Foundry Networks (NASDAQ:FDRY). I'm not sure it's possible to provide a similar analysis of the relative values of a Picasso and a Monet, or an 1823 dime and a Mickey Mantle rookie card.
Problems unique to collectibles
Beyond valuation, there are many problems that those who wish to "invest" in collectibles have to navigate.
There is an inherent market imbalance in the collectibles world -- regular folks typically buy at the retail price and sell at the wholesale price. While many investors would be furious about paying a 4% or 5% spread in the stock market, many collectors would be thrilled to see just a 10% or 15% spread between the "buy" and "sell" price.
Second, the health of a collectibles market is inextricably tied to the level of interest in that market. Granted, certain collectibles -- coins, stamps, baseball cards, diamonds -- have a long history of interest, and collectors can usually find buyers and sellers in any city of meaningful size. But that's not always true of more specialized or esoteric collectibles.
Lastly, twisting a collectibles hobby into an investment exercise can spoil the fun of both. Hobbies should be just that -- enjoyable diversions that take you away from the stresses and demands of your work and personal life. If people become uptight about whether they're going to make a killing from their latest antique or art purchase, they may find themselves losing their initial enthusiasm and love for the hobby.
The dealer's edge
There certainly are people who make money by investing in collectibles. By and large, though, these people are dealers -- people who treat the trade of collectibles as a business and so can rightly view their ownership of collectibles as a piece of a (hopefully) growing business.
As dealers, they have the opportunity to buy wholesale and sell retail. That aforementioned 10%-15% buy-sell spread puts food on the dealer's table and covers his or her inventory risks.
Dealers also talk amongst themselves, and they often share information with each other that they wouldn't divulge to all but their best customers. As such, they are in a good position to know what's selling well and position themselves accordingly.
For instance, most of the coin dealers I know bought up gold coins whenever they could in the late '90s and early 2000s, when gold was low, and sold a lot of them in the past couple of years. Now that gold's hot, they're trying to buy fewer gold coins and more of the unloved coins that now sell at lower prices -- expecting, of course, that prices will reverse again in the future. Amateur collectors have been buying a lot of gold coins lately, but they might have to wait a long time to see any gain from them.
How to profit from a hobby (if you really must.)
I hope that by now, you've abandoned the notion that collectibles are as sound a purchase as Starbucks (NASDAQ:SBUX) or Microsoft (NASDAQ:MSFT), but I'm sure some people will absolutely insist upon trying. So here's how to make the best of a tough situation.
Get yourself as educated as possible -- learn everything you can about your hobby and the trends that make it work. It's also a very good idea to locate and secure the services of a well-connected and reputable dealer.
It is also critically important that collectors and hobbyists avoid overspending on their avocations. Most collectors get a psychological "rush" from their new acquisitions; it can take considerable discipline to keep within a sound budget.
Success with collectibles demands that the collector be either exceptionally nimble, moving in and out of hot trends, or exceptionally patient. Trends can take literally decades to sort themselves out. Additionally, it can take years of price appreciation to recover from the bid-ask spread and make a profit.
The bottom line
Hobbies are great. They're one of the ways I've been able to maintain my own sanity while working in and around the real financial markets. But mixing hobbies and investments can spoil both and ultimately cost the collector a lot of money.
While you might be able to buy a painting from the next Rembrandt or discover a valuable armoire at a yard sale, the odds are against you. Most hobbyists who attempt to parlay their collections into investments will find themselves on the short end of the stick and holding items that are as popular as velvet portraits of Elvis.
Investing in faceless conglomerates like Wal-Mart (NYSE:WMT) or GeneralElectric (NYSE:GE) may not be as emotionally satisfying in the short run, but it's a more reliable way of building your personal wealth over time.
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Fool contributor Stephen Simpson owns shares of Johnson & Johnson but not of any other companies mentioned in this article. The Fool has a disclosure policy.
