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Virtual Money

May 5, 2000 10:06 AM   By Martin Rapaport
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Martin Rapaport

The advent of the electronic era (E-era) has enabled the popularization of many high tech devices and concepts. One of the more fascinating concepts that defines the E-era is the notion of virtual reality. Virtual reality is the simulation of real world situations by sophisticated computer systems that alter the perceptions of the user in an interactive environment. In other words computers and software create an artificial world that appear so real we treat it as the real world. In effect our perception of reality is changed by the man-machine interface to the extent that we not only believe we are in a different state of reality, we are in different a reality, a virtual reality.

For example, a pilot in an airplane simulator feels and experiences the same thing that he would experience in a real airplane even though the simulator has never left the ground. The reality is that the pilot is in an enclosed box on the ground while the perception or virtual reality of the pilot is that he is soaring through the sky.

The amazing thing about virtual reality is that the human mind is quick to adapt to the interactive electronic environment. For the duration of the experience, the artificial world becomes more real than the real world. Our minds and bodies substitute an artificial state of reality for the real thing. We can’t tell what is real and what is not, as we experience an altered state of reality. Often, as in the case of a pilot, the artificial world is so real that it is virtually the same thing as having the experience in the real world.

The underlying concept of virtual reality extends far beyond the man-machine interface and is rooted in basic psychology. Man, and indeed all intelligent beings, does not react to reality. We react to our perceptions of reality. Everyone from Pavlov’s dog to the most sophisticated stock trader reacts to what they think is going on around them, not necessarily to what is really going on around them.

The notion that perceptions of reality are more important than reality is not anything new. In fact, the idea that people react to what they perceive as reality rather than real reality is the primary motivation behind marketing and advertising.

Consider two competing diamond sellers with the same amount of inventory. Firm A spends 100 percent of its diamond budget on product. Firm B spends 70 percent of its budget on product and 30 percent on marketing. Obviously, firm A’s diamonds are of better quality and they should be worth more than firm B’s diamonds. However, since firm B spends a large amount on marketing, the perception among buyers is that firm B’s diamonds are better, even though they are not.

Will customers buy the diamonds that are really better, or the diamonds that they think are better? Marketing research shows that customers will always buy what they perceive is better. And that is the proof that the perception of reality is more important than reality. So what is reality? Is it what really is, or is it what we perceive it to be?

Money

The incredible boom in the U.S. stock markets over the past few years has had a major impact on the U.S. economy in general and the diamond industry in particular. Never before have so many people become so rich so fast. Millions of millionaires have sprouted up like daisies after a rain shower. Internet stocks have not merely increased; they have shot up by hundreds and in some cases thousands of percentage points. Everyone is in the stock market. My travel agent, barber and even the taxi driver. They all have hot tips – stocks they are pushing.

While the boom has abated and the markets have corrected somewhat since the beginning of the year the wild ride continues as increasing volatility push stock prices up as well as down. People are making and losing money much too easily. It is hard to ignore the uncomfortable sensation that we are living in a bubble.

Given the fact that diamonds are a luxury product and therefore highly sensitive to shifts in the external economic environment, it is only natural that we should be concerned about the overall state of the economy and its potential impact on the diamond industry. I don’t mean to alarm anyone, or rain on the current parade of prosperity, but shouldn’t we be asking a few obvious questions?

How sensitive is diamond demand in general and diamond prices in particular to changes in the stock market? Is the diamond industry currently at risk? How should the diamond industry deal with the challenges presented by volatile stock markets? How do consumers relate to their newfound wealth and what impact does this have on diamond demand? What is really going on out there in the equity markets? Is the bubble ready to burst? What if it does? What if it doesn’t?

Stock Market

Diamond demand runs the full gambit of price points. Diamonds are no longer an exclusive product for a limited class of rich people. Inexpensive diamond jewelry priced at $500 or less at retail probably accounts for at least half of all diamond demand.

While the stock market boom and high flying internet stocks have played an important role in increasing wealth in the U.S., it is worthwhile noting that the primary force promoting broad based demand for inexpensive to mid-priced diamonds is not the stock market, but rather the overall strength of the U.S. economy. Factors such as the level of employment, disposable income and consumer confidence play a much more important role defining diamond demand than does the stock market. It therefore follows that demand for everything except high price-point diamonds are not very sensitive to short term fluctuations in the stock market. Provided the stock market does fall so drastically as to drag down the general economy most of the diamond industry has very little to fear from the shenanigans on Wall Street.

The market for larger better quality diamond and certs has benefited significantly from the wealth effect created by sharply higher equity prices. Here too however, the risk presented by a decline in the stock market is mitigated. Prices for expensive diamonds have not increased significantly over the past few years. While many of us wish that diamond prices would do as well as equity prices – the fact that they have not protects us. Prices for expensive diamonds are very conservative and ridiculously low when compared to the surging equity prices. Simply put, diamonds didn’t go up significantly, so diamonds are unlikely to go down significantly. What has happened is that the volume of sales has increased and this volume may decrease if there is a significant downturn in the equity markets.

In general, the diamond industry should watch developments in the stock market carefully, especially the segments of the industry that specialize in larger, more expensive diamonds. However, barring a major collapse significant enough to damage the overall economy, fears that stock market volatility will significantly damage diamond demand in the short term are probably overstated.

The old Yiddish proverb “no tree grows to the heaven” is probably well applicable to the current state of the equity markets. But we should not be over-alarmed. After all just because a tree stops growing does not mean it falls down.

Virtual Wealth

A greater challenge facing the diamond industry is the long-term stability of the new wealth driven U.S. economy. Over the past few years we have transitioned from a world of real wealth – where people have money in the bank – to a world of perceived wealth – where people have money in the stock market or stock options. We are moving towards a new economy where people make money from money, or from the opportunity of making money.

One of the primary forces fueling consumption in the U.S. is the confidence that people have in their wealth and their ability to acquire wealth. Consider the individual who has made large amounts of money in the stock market or holds options in his company that have appreciated greatly over the years. Now this un-cashed-out money is perceived by the individual to be real wealth. But is it real wealth or just virtual wealth?

It appears that the U.S. economy has entered a new cycle of expansion based on virtual wealth. A world where people prefer to work for stock options rather than cash. Where the economy is as much driven by future expectations of wealth as it is by cash in the bank.

Virtual Money

One good example of virtual money is stock options that are given to an employee in lieu of real money. These options reflect an opportunity to earn large multiples of money in the future instead of real money in the here and now. To some degree they are lottery tickets with variable pay out rates dependent on the success of the company’s IPO.

Interestingly, the value of option virtual money is based on the value of the IPO stock, which is based on the future potential earnings of the company. The reason people pay very high prices for stocks of internet or high-tech companies is not because these companies are earning money, but because investors predict that the companies will be positioned to earn huge amounts of money in the future. In effect investors are valuing companies based on the present value of future potential earning rather than real earnings.

What we are seeing is the financial leveraging of the future economy into the here and now. A new wave of wealth is flowing into the markets based on the present realization of future potential earnings. Everyone, the employees working on options, the conservative executive with a pension fund, the taxi driver, the stock player, all are investing based on a perception of future reality. The perception is so strong that it has become real. With real money payouts for those who sell their options, or stocks. A trend has been set in transforming real markets into virtual markets. It is as if Wall Street and the most creative people in the country have entered into a very large flight simulator. They are on a virtual trip – a trip that they prefer to the real thing.

Reality Check

How solid are these markets? How long can they last? Should diamond companies be building inventories over the long term based on the reliability of the newly developing virtual economy? Can the bubble last?

It is hard to say what is real and what isn’t in the current environment. After all, is a better quality diamond worth more than a lower quality diamond with a 30 percent advertising premium that improves its perception of value.

Sure the market will correct and the economy will turn. But will it correct so strongly or turn down so sharply that we should be pulling out? Who can afford not to be a player? Who has the guts to short the market?

Caution

Fortunately, the diamond industry is not where it was in the late 70’s. Our prices are normal and while our business is strong it is not crazy. We are not being forced to gamble in order to play the game.

Internet companies will probably come and go. The stock markets will rock and roll. The key advice we can give is not to be too taken in with the wild opportunities of the moment. Don’t be in a hurry. At the same time we caution, do not reject the new virtual economy. Take time to find virtual opportunities. One way or another these virtual markets are becoming more real every day. Over the long-term today’s virtual reality will become tomorrow’s reality.

The real world has become a world of perception, a virtual world where opportunity refuses to be limited by old-fashioned norms of reality. What we are seeing now may not just be a short-term virtual bubble but rather the beginning of a new form of economy that takes rational expectations to their highest levels. A virtual world that has become a reality.

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Tags: Consumers, Economy, Jewelry
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