What is the 'Appraisal Approach'

The appraisal approach is a procedure for determining an asset's value. The appraisal approach values assets based on a number of factors, such as its cost, the income it generates or its fair market value as compared to similar assets. A different dollar value will be assigned to an asset depending on which of these factors the appraiser primarily bases his or her estimate on. Sometimes the appraised value will not coincide with an asset's market value, and buyers will often pay more or less than an asset's appraised value based on what the asset is worth to them. No matter which appraisal approach is used, an appraisal is only an educated guess as to what price the asset would fetch in a free market.

BREAKING DOWN 'Appraisal Approach'

The appraisal approach involves appraisals used to determine the worth of high-value assets such as real estate, jewelry, businesses and vehicles. They are usually performed in conjunction with a sale or for insurance purposes. For the results to be taken seriously, an appraisal must be conducted by an individual with expert knowledge of the asset being assessed. A diamond ring should be appraised by a jeweler, and a business should be appraised by a valuation firm.

Many alternative assets do not have a current market price because they do not trade hands regularly. This may include art, financial interest in an oil field, or any asset that's unconventional, but has value. These assets are generally appraised to establish a fair value.

Real estate, although more conventional than the sort of securities falling under the alternative investment umbrella, also suffers from irregular transactions. As such, many real estate assets or portfolio must also be appraised.

Valuation "smoothing" is the biggest issue when asset appraisals are used as a method of establishing value. Smoothing occurs when the variability of asset prices are smoothed or biased downward because of estimation in valuation. As such, true volatility can be suppressed relative to transaction-based valuation methods.

When hedge funds first became mainstream, many fund's volatilities may have been inadvertently lower than actual performance, because of reliance on appraisal valuation techniques. Today, deeper capital markets and methods to remove biases have helped paint a truer picture.

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