What's your passion? Fine art? Coins? Wine? One in three Americans collect something. Even collections that start as hobbies can quickly build in value to thousands, or even millions, of dollars. Once a collection becomes a significant part of someone's net worth, it should be considered in any wealth management strategy. But few collectors or advisors take this view.

In addition to satisfying an emotional need, collections of antiques, fine art or stamps may offer financial benefits. In fact, over time many collectibles have earned higher returns than traditional investments like stocks. They can be used to diversify an investment portfolio or hedge inflation.

But you also need to keep in mind that they involve costs, risks and tax liabilities that are different from other assets.

Thinking Like an Investor

For many people, their collections are like the homes they live in-only becoming 'investments' when their values rise. When values decline, those same collections morph back to simple passions. By permanently including these assets on their balance sheets, collectors can work with their wealth managers to ensure that they maintain an appropriate mix of risk, return and liquidity.

Treating collectibles as an asset class is tricky, however. There are many widely available indices for equities and bonds that show how they affect potential risk and return in a portfolio. Finding reliable data for collectibles is more difficult. Pricing guides list auction results and "expert" opinions on value, but do not reflect prices from private sales. Most indices available for tracking market trends only cover sub- categories of collectibles, such as "fine art" or "rare coins."

Some of these indices have relatively short histories. Others, like the Antique Furniture Index published by Antique Collector's Club in England, has been calculated annually since 1968 using retail prices from shops, fairs, markets and auctions. Over the 40 years ending Dec. 31, 2008, this index returned 7.5%, on average, annually versus 5.7% for the S&P 500.

Measuring Risks and Returns

To examine price trends in the overall collectibles market versus other asset classes, we constructed a "collectibles basket" based on the following indices.

Liv-ex 100 Fine Wine Index: Tracks the 100 most popular French, German, and Italian wines with a secondary market, weighted for scarcity.

Artprice Global Art Index: Tracks the Artprice auction database of more than 25 million auction results from more than 2,900 auction houses worldwide.

PCGS 3000 Index: Tracks 3,000 rare copper, silver, nickel, and gold U.S. coins.

Stanley Gibbons GB30 Rare Stamp Index: Tracks 30 rare British stamps.

Further analysis showed that our collectibles basket is positively correlated with most other asset classes-with the exception of bonds. This means the prices of a collection will likely move in the same direction as these assets and in the opposite direction of bonds. We also found that collectibles are positively correlated to the U.S. economy.

On the surface, collectibles seem to offer an attractive balance of risk and return. However, collectors should be aware that a lack of liquidity may smooth out volatility and make collectibles riskier than they appear.

One must also consider the opportunity cost in tying up money that might earn better returns in the equity or fixed income markets-or the risk that a collectible will fall out of favor and earn little, if any, return. Additionally, actual returns may be reduced by costs for purchasing, holding and selling items in the collection.

Finding the Right Allocation

Most collectors, of course, are not trying to hedge inflation or diversify their portfolios. They simply have a deep connection with antique china, baseball cards or bottles of wine. That said, incorporating sizable collections into a larger wealth management plan can help to assure adequate liquidity and avoid over-exposure to risk.

Developing a precise asset allocation strategy for collectibles can be difficult. This requires a history of accurate valuations or reliable benchmarks that can be used for modeling-which, as we have noted, may not be readily available. Research by Ibbottson Associates sets 10% as the maximum allocation for private equity investments in a well-diversified portfolio. Given that collectibles have similar liquidity and appraisal risk, a 10% ceiling seems to make sense. But remember, a lack of ready liquidity in a collection may make it tough to rebalance a portfolio overweighted in collectibles.

Since collectible markets generally seem to be sensitive to the economy, albeit with a time lag, an investor with a large collection might simply lighten up on other economically sensitive assets. Given the lack of cash flow from collectibles, it is also important to make sure there is sufficient income from other sources-especially if the portfolio includes other illiquid assets such as real estate or a family business.