Diamonds: don't buy into the illusion

There was a fine picture in the newspapers this weekend of Johan Dippenaar of Petra Diamonds holding up a large diamond. A very large diamond it came in at over 500 carats (the average engagement ring is well under one carat). And, being entirely flawless, had just been sold to a Chinese buyer for $35.3m.

So did the buyer get a good deal? That's hard to say. The financial crisis hasn't been good to diamond prices. By mid 2008 the market for new diamonds had all but collapsed. Polished diamond prices fell by a third as retail sales just vanished (30% of US jewellery stores have shut down since the crisis kicked off) and rough diamond prices fell around double that.

So what next?

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The industry says that the worst is over, that prices have bottomed out and that those of polished diamonds are steady.

And the brokers are tipping diamond miners again. They say that there have been no good diamond finds since the 1990s, so supply could soon be tight. They also point to the huge GDP growth in China as a forewarning of fast-rising demand from the middle class for polished stones (which is presumably why Hong Kong's Chow Tai Fook Jewellery wanted Petra's stone in the first place).

But this might be an area where only fools rush in.

For starters, note that a lot of the things you belive about diamonds aren't really true. Diamonds aren't rare. Turn on to QVC for an hour during one of the jewellery sales if you aren't convinced. No obvious shortage there.

Or take yourself off to a country auction: there you will find you can buy handfuls of second-hand diamond jewellery for a couple of hundred quid.

And right now there are even more diamonds about than usual. The industry is living in fear of Alrosa (which controls 97% of Russian diamond production) dumping its huge inventory on to the market and pushing prices down in the process. The firm did not cut production during the crisis, so its stock of unsold diamonds is now ludicrously large.

Alrosa's vice president told the Antwerp Diamond Symposium late last year that the company would "approach its inventory in a responsible manner." But the point is not how they dispose of it but the fact that the inventory is there at all.

The truth is that when you buy a diamond you buy an illusion you pay a high price for perceived scarcity when there is actually none. Diamond prices rest on little more than the retail market continuing to buy into that high-cost illusion.

But with the Americans (still the largest diamond market in the world by a long way) desperately deleveraging and the Chinese miracle clearly at risk, I'm not sure that is something ordinary investors should be betting on.