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At the end of a nerve-racking year in volatile markets, wealthy investors who have poured money into art can take solace in the fact that their alternative investment of choice seems to be holding up remarkably well. But it would be wishful thinking to count on it to help cushion the financial blows if 2019 turns into a nasty year of the bear.

Art’s growing allure as an investment vehicle is easy to understand. Auction prices have been smashing records; global revenue has soared; art-backed lending has taken off; and a growing number of wealth advisers are touting art to well-to-do clients looking to diversify their assets. Dozens of art investment funds have sprouted up to meet the demand.

“The contemporary art market is a perfect playground for investors,” Artprice, which tracks global trends, sales and prices, gushes in its latest assessment. “The wealthiest pay top whack for works by [certain] artists … whose prices inflate at a phenomenal pace, generating capital gains measured in hundreds of thousands of dollars, or even millions.”

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That sounds suspiciously like an overheating market, whose well-known drawbacks – not least a lack of transparency, rampant insider dealing and the absence of regulation – should already be flashing warning signals to those viewing art as a potential haven from the stock market’s storm-tossed seas.

“There are always momentum buyers who get excited when things are happening. And they think they can outsmart the market,” says Christopher Varley, a veteran Canadian private art dealer and former curator.

“People who think they’re canny, hard-nosed investors invariably step on a rake.”

Various indicators “all point to the contemporary art market as a looming price bubble,” economist Don Thompson writes in The Orange Balloon Dog: Bubbles, Turmoil and Avarice in the Contemporary Art Market, his 2017 examination of the inner workings of the US$60-billion-plus global market. “The main explanation for the huge sums of money changing hands is wishful speculation, both for iconic works of art and for work by emerging artists.”

That bubble is likely to deflate or burst “sooner rather than later,” with predictable consequences for the market, Prof. Thompson says in an interview.

“If the art bubble begins to deflate, guess what happens?" asks Prof. Thompson, an emeritus professor at York University’s Schulich School of Business. “Think of the stock market. Who wants to be the last one out the door?”

As the 2008 financial crisis underscored, diversification doesn’t offer much protection when everything is headed in one direction. Art’s plunge in the second half of 2008 and first part of 2009 mirrored the debacle in real estate and equities.

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The number of contemporary works sold at auction for US$1-million or more nosedived nearly 80 per cent between 2007 and 2009. On the lower rungs of the ladder, prices fell as much as 60 per cent. And works by lesser-known artists often went unsold amid a flood of gallery closings and cutbacks.

“When the market for an artist’s work is seen as illiquid, it is hard to sell at any price,” Prof. Thompson says.

Leaving speculation-fuelled bubbles and crashes aside, he isn’t a big fan of art as an investment.

“Art produces no income stream, just a potential capital gain. In this sense art is more like gold than like stocks, bonds or real estate,” he writes in The Orange Balloon Dog. The title comes from the stainless-steel sculpture by Jeff Koons that was sold at auction to a deep-pocketed speculator in 2013 for US$52-million, eclipsing the previous record for a work by a living artist by 50 per cent.

“The lack of a pricing model means that art is subject to fads, fashions and price bubbles. … It also means that an investor must cover both capital and financing costs of art from some other funding source, while hoping that the asset appreciates enough to justify the expense.”

The dazzling numbers Artprice and other market watchers rave about stem from high-end auction results, which are skewed by the astounding amounts forked out for the biggest names. In the contemporary market, auctioned works by just three artists – the late Jean-Michel Basquiat, Peter Doig and Rudolf Stingel – accounted for more than 20 per cent of the segment’s global turnover in the second half of 2017 and the first six months of this year.

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A painting by Mr. Doig, The Architect’s Home in the Ravine, fetched just under US$475,000 when it was sold at auction in 2002. When the British artist’s celebrated work, inspired by a visit to a house in Toronto’s tony Rosedale neighbourhood, was auctioned for the fifth time last March, the price tag was nearly US$20-million.

“You only read about the successes,” Prof. Thompson says. “No one ever promotes the work that was bought for $25-million and sold for $6-million.”

About half of all sales occur through dealers or in private transactions, often at lower but rarely disclosed prices.

Using a reliable index maintained by the major art insurers, he reckons that over a long period, higher-end art appreciates about 3.2 per cent a year. The cheaper stuff doesn’t show up in the insurance data because it’s not worth the high cost of coverage.

Indexes that track auction prices produce substantially higher figures, but these don’t include art that’s fallen out of favour and doesn’t get resold. “It’s like measuring the stock market only through stocks that go up.”

For wealthy investors still eager to get into the art game, the best course would be to stick to the same approach that works best with other types of assets: limit your exposure, diversify to reduce risk and focus on fundamentals.

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If you want to view art as an asset class, “don’t go above 7 per cent of your [total] investment assets, get a good art adviser and diversify,” Prof. Thompson says. “For your $1-million, you’re better off to buy five works from five different promising artists than you are to buy one.”

Mr. Varley, the veteran private art dealer, describes himself as a conservative stock market investor. “You really buy the company, not the stock, and you trade on earnings and corporate fundamentals, not on price. I think you have to buy art the same way. You’ve got to trade on the fundamentals and whatever intrinsic value exists.”

But he adds: “I’d much rather have the relative certainty of dividend growth [from equities] than the absolute uncertainty of capital gains when it comes to art.”

You can then spend some of that dividend income on art you would love to see on your walls, which beats staring at gold bars and bitcoin accounts.

The astute art investors “are quite disciplined [and] keep most of their money in other assets,” Mr. Varley says. “For the record, I’ve made much more money in the stock market than the art market, and I’m supposed to be one of the smart-money insiders.”

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