Gemology is the practice of identifying, studying and evaluating gemstones. Gemstones can be extremely valuable, and because they carry an additional aura of mystique, they have become a hot investment alternative. But they're definitely not suitable for every investor. We'll unravel some of the mystery that surrounds gemology and explain why only investors with significant risk capital - and risk tolerance - should consider trying to profit from trading gemstones. (For more info, read What are the components of the risk premium for investments?)

TUTORIAL: 20 Investments You Should Know

Gems as an Alternative Investment
Many wealthy investors overlook the disadvantages of gemstone investing because of the potential for exponential gains. Gemstone investing is one of the riskiest kinds of investments; there are many ways to lose invested capital including fraud, political risk, subjective valuations, low liquidity and the potential for stones to be damaged when they are cut. Most of the people who invest in gemstones do so knowing that they're taking a very large risk. However, significant returns can be realized when an investor buys a large, uncut, colored stone, has it cut and then sells the gem for a lot more than he or she paid for the stone and the cost of cutting it.

Traditionally, gemstone investing has happened in the exclusive circles of certain families. A few families in Belgium, Holland, New York, Israel, Africa, Brazil and India have been involved in most of the trade of large stones. Lately, these closed circles have (by necessity) started to open up to outside investors who are willing to part with hundreds of thousands - if not millions - of dollars in exchange for a piece of the action. The main reason why new financiers are being let into gemstone circles is that more stones than ever before are being found and, as a result, buyers and traders need more money to continually finance the purchase of stones.

For those with the means and the connections, gem investments offer a great opportunity for diversification. The price of a gem has more to do with the characteristics of the stone itself, not the market in which that stone trades. Gem investing is also a great way to realize exceptional returns in a flat stock market. Even in the most bearish of markets, uncut gems can still be cut, increasing their worth by as much as hundreds of times their original price. Furthermore, buying one of the rarest materials on earth in a lavish London auction house such as Sotheby's or Christie's, having it cut in Antwerp and then selling it in Dubai is a thrill ride that would excite any tycoon. (For further reading, see Introduction To Diversification.)

The Basics of Gem Investment
If you have a mountain of risk capital and you want to invest prudently in gemstones, there are a few basics that you need to know.

First of all, there are thousands of kinds of valuable stones, but gemstones are usually limited to emeralds, rubies, sapphires and, of course, diamonds. Gemstones are valued according to a number of characteristics and increase in value exponentially if they have a perfect combination of the most desirable characteristics.

In general, the larger a gemstone, the higher its worth - even small increases in size affect the value of a stone.

A stone's grade - which is directly related to the stone's clarity - also works to determine its price tag. Two things contribute to grade: the purity of a stone and its likelihood of cleaving (breaking). Stones with no flaws are almost completely pure and are less likely to cleave during the cutting process.

The color of precious stones has always been important to valuation, but in the last decade, colored stones have experienced tremendous price appreciation. Depth of color and intensity are two of the terms that are frequently used by gemologists to describe gems. Colored diamonds, in particular, have become extremely sought after in North American markets. In fact, large, intensely colored, flawless diamonds are among the most valuable luxury items on earth.

Like precious metals, gemstones are internationally priced in U.S. dollars.(To learn more, see Determining Risk And The Risk Pyramid.)

Gems and Investment Risk
Despite their undisputedly high value, gemstone investments include very high levels of risk, which arise from a number of different factors. Professional gemologists are experts at mitigating many of the risks associated with gemstone investment, but they command very high fees. As we mentioned earlier, some unique risks associated with gemstones include subjective valuations, low liquidity, cleaving and fraud.

  • Subjective valuation: Experts don't always agree on a gemstone's worth. Anyone who buys a stone should consult with at least a couple of professional gemstone valuators.
  • Low liquidity: Because gems are rare, infrequently traded and lack a global marketplace, it is often hard to attach a firm value to a stone. Anyone considering such an investment should be willing to hold onto it for a number of years, in case a buyer can't be found.
  • Cleaving: This is the risk that a stone will break apart when cut and polished, shattering into a number of pieces that are worth exponentially less than the larger, uncut stone. Polished, symmetrical gems are much more valuable than those that are uncut and unpolished, but most gems have a tendency to cleave during the cutting and polishing process, making it a very risky venture.
  • Fraud: This is the most common risk that investors will face when purchasing gems. Unless you are or are working with a professional appraiser, judging whether or not a stone is real can be very difficult.

Despite the drawbacks, the returns from gemstone investment can be high. Beyond buying a raw stone and selling it as a polished gem, you can also buy a cut and polished stone in a down market, or buy from a seller that is having a hard time selling a valuable stone. These gems can then be either sold when the market warms up, or sold in a different country via auction or dealer. Investors buying gems that they believe to be undervalued generally have a longer-term perspective and may be willing to wait years to turn their investments into cash.
No matter your time horizon or your willingness to bear risk, unless you're dealing under the guidance of a reputable professional, gemstone investing is as close to gambling as you can come without setting foot in a casino. If you are considering investing some of your risk capital in gemstones, be prepared to spend some money on professional assistance, and remember, as always, that high potential returns always come with significant risk.

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