Last week we were on vacation at my in laws house. Close family friends joined us for the trip and a couple of nights were spent around the table competing in the board game called Wits & Wagers. We paired up into teams of two with each team consisting of an adult and a kid. If you know anything about our family, we trend toward the "more competitive" side of the ledger. It was an intense couple of nights. Well, about as intense as a game of Wits & Wagers can get!
Wits & Wagers, if you've never played it, goes something like this:
The moderator reads off a random question (example: How many Americans were injured in bathtubs or showers in 2001? I told you…random, right?!)
The players then write down their best guess in an attempt to answer the question
Once all "answers" are in, the boards are flipped over and ordered from lowest number to highest
Teams are able to "bet" with their two coins valued at $100 and $200
In our game, we had 6 teams playing and the board always has an answer of "1" so the teams’ guesses have to be from 2 - ??? depending on the question asked.
Here's how the scoring works:
If you place your $100 coin on the winning answer, you receive $100
If you place your $200 coin on the winning answer, you receive $200
You can also receive points in the following ways:
If your answer is the closest without being higher than the answer, your team receives $100
If your answer is exact, your team receives $200
A look at the betting action! Who’s diversifying?!?
It is a trivia game but you really don't have to know trivia to win. Can it help? Sure. But a player could literally play the whole game without writing down a correct answer and still win due to how scoring works (see above). Strategy is not so much a part of the guessing-I-mean-answering part of the game. In Wits & Wagers the questions are often based around statistics and deliberately designed so no one at the table likely knows the exact answer.
While we were playing (and what I'm really referring to is the betting part of the game at this point), I started to see some similarities between Wits & Wagers and investing. More specifically - Diversification.
The betting part of the game is where the most action takes place. Lots of discussion, maybe some mild disagreements among partners over where and how to bet, and plenty of "coins" being moved from one guess to another. And sometimes back again or to yet another different guess entirely. It's a hoot!
And honestly, who knows the answer to this question:
How many cups of coffee does the average American drink in a year?
Another actual question from the game.
For the most part, our answers to these questions are all random guesses. But it’s not uncommon to see a team load up on their own guess-I-mean-answer and shoot for the moon, swing for the fences, etc.
Unless you really and truly know the answer - which is pretty rare - it's a huge risk to put your entire bet for that round on one guess…err, answer. We'll call this the "All Our Eggs in One Basket" strategy.
When it comes to picking stocks or investments, it's all a random guess as well. I've beat this drum for years. If someone could accurately and reliably predict the market, why on earth would they share any of that information with anyone let alone you or me???
Plus, picking stocks or investments that consistently outperform is hard. Like "in pounds, how much potatoes does the average American eat each year?" hard (another actual question from the game).
Take a look below:
The handy dandy chart shows annual performance of major asset classes in the US, international, and emerging markets over the most recent 15-year period. The top chart ranks the annual returns (from highest to lowest) using the colors that correspond to the asset classes and the bottom chart displays annual performance by asset class.
Regardless of whether you look at US or non-US markets, there's little predictability in asset class performance from one year to the next. Do you see any kind of pattern? I sure don't.
Let's play a game.
I'm calling it Wits & Wagers: Your Money Edition. I’m your host, Darren Straniero and heeeeeeere are the rules:
You have $100,000 to invest on Jan 1, 2009. You HAVE to put it in only one of the asset classes below. You are only allowed to look at the performance from the year prior (2008). Ready, go!
Looking at the performance now, it would be easy to say Emerging Markets…lol! But how many of us would be scared out of our minds to put our money in that asset class having seen it was down -53.2% the year prior??!!!
I imagine lots of hands raised.
Remember: in our Wits and Wagers board game there are lots of guesses out there and everyone is participating. Sometimes we can be swayed by another team's guess and/or bets. And we might *think* they actually know something about the topic. This is not unlike the financial media and their expert opinions (read: guesses) telling us what to do and where to invest.
Now let's go back a year - Jan 1, 2008 - and our game rules are the same. You can only put your money in one asset class and only have performance data from the year prior. Emerging Markets returned nearly 40% and was the TOP performer that year among our listed asset classes.
How many of us would be champing at the bit to wager on Emerging Markets now?
Again, I imagine lots of hands raised.
In both editions of Wits & Wagers, the payoff can be tremendous. When it comes to investing, huge rewards also tend to carry huge risk. In real life, this example would not be unlike an individual who holds a large concentration of his/her employer's stock. And this is the basis of the "All Our Eggs In One Basket" strategy.
Let’s not forget we are making a prediction merely on past performance. A guess. We call this speculation. Maybe it's for you. If not, keep reading.
Our next Wits & Wagers board game betting option is to bet a little bit on our own guess and bet some on one of the other team's guess. In gambling terms, this is called "hedging". The same theory can be applied to investing. By splitting up our investments we increase our chances that we’ll “pick” a winning investment. It’s a little bit of diversification.
In our Wits & Wagers: Your Money edition, let's diversify our “bet” this time with bonds. We pick emerging markets because it was the top performer in 2007 and we diversify with a 5-year bond portfolio because it was the 2nd best performer in 2007 (see the quilt chart above). And the split is 50/50, just like in our Wits & Wagers board game.
Had we only invested our $100k in emerging markets, we know we would have lost a whopping -53.2%. Oops. But because bonds did not go down in value in 2008 like the rest our "portfolio" we only suffered a -22.2% decline in value overall. We don’t love this but overall it’s a better result because we diversified a little bit. The bonds acted as a buffer against the complete and utter whiff on our Emerging Markets guess.
In our Wits & Wagers board game we would have won a little bit of money and had something to show for our effort. Diversification is working here. And diversification, like all investing, requires good investor behavior - meaning we have to ride the waves like our son, Sutton.
Because we also stuck with it the next year when Emerging Markets "emerged" again to the tune of a +79% gain, our "diversified" portfolio climbed up to ~$95,000 or nearly where we started. Not too shabby especially considering the alternative.
Here’s the alternative: we know if we only invested in the Emerging Markets portfolio we would have suffered through the -53.2% year that was 2008. Had we not panicked and bailed (by either choosing another investment or getting out of the market altogether) we would've been rewarded with that +79% gain. That strategy would have only netted us a hypothetical account value of $83,772 at the end of 2009.
Key Point: when compared to our EGGS IN ONE BASKET + PICK THE WINNER STRATEGY, our “diversified” strategy would have resulted in both a smaller loss in value for 2008 and a higher overall portfolio value at the end of 2009. Interesting.
Let's take a quick break from the action to remind everyone my examples above and through the duration of this are not recommendations but merely an effort to show how diversification can work and the importance of it. And we're also using very short term time horizons to further simplify how diversification works. As you may recall, investing is a long term endeavor and you cannot time or predict the markets with any type of consistency or accuracy.
Okay, back to the action…
Our third and final Wits & Wagers board game betting strategy is to not bet on our own guess and spread our two coins among our opponents' guesses. Remember, we still get "paid" if our guess is the closest answer so there's no need to bet on our own unless we're SUPER DUPER confident in our guess I mean answer. Again, this is a rare occurrence so the prudent long term play is to spread it out and increase our odds of getting paid. By ignoring our own guess and betting on two additional guesses, we now have three chances to win some money. Giddy up!
In investing terms, we are further diversifying when we add additional non-similar investments to our mix. Example: stocks and bonds, domestic stocks and international stocks, large cap stocks and small cap stocks, etc.
“If everything in your portfolio is up at the same time, you are NOT diversified.” - Michael Kitces
This time we’re going to use three investments to further illustrate how diversification works. Our examples are a Large Cap fund (S&P 500 Index), some Real Estate (Dow Jones US Select REIT Index), and some bonds (Bloomberg Barclays Treasury Bond Index 1–5 Years). The chart to the right shows the returns of each asset class year over year.
Other than 2008 and 2009 when our Large Cap and Real Estate funds had similar performance, there's not much of a consistent pattern among our three funds. A lot of zigging when others were zagging. Some are up more than others depending on the year.
And there isn’t a single year in here when all three of our investments experience negative performance. That, my friends, is a simplified example of diversification at work.
When we put it all together and illustrate it with a balanced and fully diversified 60% stock and 40% bond model portfolio, it looks like this:
It’s a pretty smooth ride from 2004 to 2018. We’re holding ALL of the asset classes I showed you up above in the “quilt pattern” chart. We experience the ups and downs of all of the asset classes simultaneously. Some are up when others are down. And some are down when others are up. But as a whole, they’ve moved up.
NOTE: if we held more stocks, we would have seen more zigs and zags. More bonds? Fewer zigs and zags than what we see just above.
IMO Wits & Wagers is a super fun board game. The reality is you don’t need to diversify your bets to win. In fact, it might not be the best strategy. If you want to load up and take a ton of risk to try and win, knock yourself out. It’s just a board game. When it comes to investing, we all have a lot more at stake. It’s a different kind of game we’re playing. Diversification can help you spread out and minimize the risks in your portfolio. So let diversification do its thing. Zig and zag. Ying and yang. Ham and egg.
Wits & Wagers.