Lack of Fungibility
Every diamond is as unique as a snowflake. This makes creating an investor-oriented marketplace extremely difficult.
When you buy a share of IBM, or a Krugerrand gold coin, or even a crypto asset like bitcoin, you know exactly what you’re getting. Every one of those things is identical to every other of those things—in terms of value. This is called ‘fungibility.’
Diamonds are the opposite. While the GIA created the “4 c’s” diamond grading system that allows diamonds to be measured on four specific metrics (color, clarity, carat-weight, and cut-quality), these do not—on their own—create fungibility. In other words two diamonds—for example, which are both H color, VS2 clarity, 1.20 carat weight, and Triple Excellent cut grade, will not necessarily be identical visually, and their value may vary considerably in the marketplace.
How is this possible? Because there are attributes which do not show up in the 4 c’s, which nonetheless do affect visual beauty, and marketplace value.
A trained diamond expert will know what those are, and will value a stone accordingly. The typical diamond buyer seeking asset diversification will not have that knowledge.
But it gets worse. Some types of diamonds are better for asset diversification than others. The common wisdom says that diamonds purchased “for investment” should always be the finest diamonds, in terms of color, clarity, size, etc. This is nonsense. It’s like saying the only type of real estate that should be purchased for investment is prestige street-level retail space in Manhattan, London, or Hong Kong. That is certainly the most expensive real estate. But is it the best for asset diversification? Probably not.
So what diamonds are best for asset diversification? In our opinion: diamonds which are not only easy to buy, but which are also easy to sell. Because an investor needs to do both.
And liquidity for a diamond is best achieved by:
- Round diamonds, with a classic “brilliant” cut. Referred to in the industry as RBC’s (Round, Brilliant Cut.)
- Diamonds which rank well on the 4c’s. For example, I or better color, VS2 or better clarity, and Triple Excellent (the best) for cut-quality. From there, carat weight can be a function of one’s budget. Any diamond below these standards will likely be less liquid.
- Diamonds which are most likely able to be purchased (bid on) by experts in the trade, without being seen. This eliminates a large percent of diamonds which have “issues” beyond the 4 c’s, or as the industry refers to them: “problem stones.” (Strong fluorescence, graining, clouds, and more.)
- Diamonds which are a low enough price point that the market is deep. This would generally eliminate diamonds more expensive than $100,000 wholesale price. However, if liquidity (being able to sell quickly) is not a concern, then there’s nothing wrong with a higher price point diamond.
Also in the opinion of management, the narrowest bid/ask spreads (in/out cost) is best achieved by:
- (Same as above.) Diamonds which are most likely able to be purchased (bid on) by experts in the trade, without being seen. This eliminates a large percent of diamonds which have “issues” beyond the 4 c’s.
- Diamonds which are a high enough price point that the cost of reselling the diamond is relatively modest as a percent of the diamond’s total value. This would generally eliminate diamonds less expensive than—say–$5,000 wholesale value.
Most anyone in the diamond industry would agree with these statements:
- The higher the price point of the diamond, the lower will be the bid/ask spread.
- The higher the price point of the diamond, the more difficult it may be to sell (find a buyer.)
- The more “issues” a diamond has (problems that can be seen on the GIA certificate, but which are not reflected in the 4 c’s), the less likely someone from the diamond industry will be willing to bid on it, sight unseen.
The point of all this, is that it’s complicated. A diamond’s lack of fungibility means someone buying a diamond for asset diversification must have some familiarity with these issues. And most such buyers—not in the diamond industry—don’t.
Lack of fungibility means asset-diversification into diamonds is far more problematic than for diversification into hard assets which are fungible (such as metals). This is one of the main reasons diamonds have never become as popular as they could be, for asset diversification.
The diamond industry is organized around selling new jewelry. Other than the local pawnshop, there is no obvious place to sell a diamond when it’s time to liquidate.
Unlike, say, eBay, the diamond industry does not function as a two-way marketplace. It is generally a one way marketplace: with diamonds coming out of the ground, through a cutter (manufacturer), through a wholesaler (often the same as the manufacturer), and to a retail jeweler. The consumer then buys the diamond from the retailer.
It is very easy to buy a diamond. Just walk into a retail store. But selling it is very difficult. The typical consumer has no access to the diamond industry other than the retail jeweler themselves, or a local pawnshop. To sell through either of these is feasible, but it means a large markdown over the purchase price—as explained in the next section.
Brutal Buy/Sell Spread
Unless you’re in the diamond business yourself, you will buy at retail, and sell far below wholesale. That’s a terrible way to preserve wealth.
The markups that exist in the diamond industry are not based on greed. They are based on business necessity—as is true in most industries.
To begin with, let’s define these terms:
Retail price – the price at which a diamond might be sold to a consumer, from a retail jewelry store.
Wholesale price – the price at which a retail jewelry store would buy that diamond from a diamond wholesaler.
Sub-wholesale price – the price at which the diamond wholesaler might have purchased the diamond.
Retail liquidation value – the price at which a consumer might have to sell the diamond to a local retailer or pawnshop.
Take a diamond in a price-point range that might be suitable for asset diversification. We’re going to assume a diamond that would sell at wholesale for $10,000.
Wholesale Price = $10,000
Retail Price = $13,000. (Markups could vary between perhaps 20% and 50%. We’re assuming 30% in this example.)
Sub-wholesale Price = $9,500
So the consumer buys the diamond for $13,000, and now wants to sell it. The only access to the diamond industry available to the consumer is to sell it to a local retailer or pawnshop. How much will the local retailer pay for it?
Not $10,000, because that’s what the retailer can buy the diamond for at any time, from a wholesaler. If the retailer needed that exact diamond, they’d already have bought it. So the retailer does not need that exact diamond. So they won’t pay $10,000 for it. The retailer will pay something less than that, so the retailer can ‘flip’ the stone back to a wholesaler in New York or wherever.
The Wholesaler in New York can buy that diamond at anytime, for $9,500. So to entice him to buy a diamond he doesn’t need (if he needed it, he’d already have bought one) the price has to be below $9,500. Let’s say $9,000.
So if the retailer is going to “flip” the stone back to a wholesaler (and make money on the transaction) he can’t pay the consumer $9,000. He has to pay the consumer something less than $9,000. Let’s say $8,500. Remember, if the retailer can’t make money on the transaction, he won’t do the transaction. That’s simple business.
So the consumer will sell the diamond to the retailer for $8,500. The retailer will make $500 by selling it to the wholesaler for $9,500. The wholesaler will have gained a value of $500 by having purchased the stone for $500 less than his normal cost—and he’s willing to hold it in inventory because of this savings.
All this makes perfect sense, and is simply how the diamond marketplace works. Everyone is being compensated fairly for the work they’re doing.
But consider the bottom line. The consumer who purchased the diamond for $13,000, now finds he can sell it for no more than $8,500. That’s a $4,500 loss on a $13,000 asset. That’s a 35% drop, or put another way, a 35% bid/ask “spread”.
If the price point was considerably lower, such as around $2,500 retail price (a typical diamond engagement ring price point) the spread would probably be 50% or more.
This brutal bid/ask spread is sufficient to make diamonds problematic for asset diversification.
If you need to sell a diamond, it can sometimes take months or longer.
The lower the price point of the diamond, the more quickly a buyer can be found, and vice versa. But the lower the price point, the higher the bid/ask spread will be. And, as with real estate, the more urgently one needs to sell, the lower value they will receive. There will always be a buyer at some price, but not necessarily an attractive price.
The lack of liquidity in diamonds—especially diamonds in the five-figure and up range—is closely connected to the lack of fungibility of diamonds, the lack of a two way market for diamonds, and the brutal bid/ask spreads involved with diamonds. These problems all tend to exacerbate each other, from the standpoint of someone diversifying into diamonds—and one day hoping to liquidate.