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Pascal’s Wager and Your Investment Portfolio

Pascal's wager and your portfolio blog postBlaise Pascal achieved fame and notoriety for several achievements.

The 17th century French mathematician did ground-breaking work in geometry and probability. He built some of the first computers and lent his name to a programming language. And he made long-lasting contributions as a Catholic theologian.

He may best be remembered, however, for Pascal’s wager: an argument for believing in the existence of God.

Pascal’s wager seems to have little to do with investing.

But it may help you sort out your thinking if you’re struggling with hard-to-handle investment decisions: expected future returns, your investment risk tolerance, the right safe withdrawal rate and so forth.

Why? Pascal’s wager suggests a logical way to come to a rational decision about this sort of stuff.

But let me start with a quick review of Pascal’s wager. And then we can move on and try to apply Pascal’s decision theory to investing.

Pascal’s Wager: A Quick Review

You can read Wikipedia’s description of Pascal’s wager if you get interested in the details, but essentially Pascal said that people can’t objectively, through reason and logic, figure out whether or not God exists.

Yet, Pascal said, people do need to make a decision.

So what should they do? Pascal said one needs to look at the outcomes of being wrong.

In terms of believing in God, Pascal points out that the downside of acting as if God exists if God doesn’t exist means someone makes a few decades of sacrifice.

In comparison, Pascal points out that the downside of acting as if God doesn’t exist if God really does exist is losing (according to Christian theology) an “infinity of an infinitely happy life.”

Enough religion, but you see the trade-off.

In some situations, you or I choose between two options. Believing one thing and acting accordingly. Or believing the opposite thing and acting accordingly.

Sometimes, we can’t really know whether the one thing or the other thing is right.

And so faced with this conundrum, Pascal says asks yourself which belief if wrong is worse to be wrong about.

We want to avoid that choice.

Applying Pascal’s Wager to Investing

The logic of Pascal’s wager works in “either this or that” situations. And many of the hard investing decisions are not really simple “either this or that” situations:

  • Are you bearing too much risk? Especially given the high stock market valuations?
  • Do I have too much in bonds? Look at the low interest rates they pay…
  • What kind of long-run investment return will stocks deliver? Shiller’s CAPE 10 ratio suggests a decade of pretty poor returns.

Nevertheless, Pascal’s wager may help you or me sort through our feelings on these sorts of issues.

How? We can ask which way we would rather be wrong.

To illustrate this with just one example people regularly argue about, ask yourself whether the stock market is dangerously overvalued.

Okay, good question.

The next question? Which decision, if wrong, is worse: Saying the stock market is overvalued when in fact it is fairly valued… or saying the stock market is fairly valued when in fact it is overvalued.

If you or I are wrong about the stock market being overvalued? Maybe we unnecessarily make a few decades of sacrifice: saving more, working longer or spending less.

And if you or I are wrong about the stock market being fairly valued? Maybe we miss the retirement we hope for.

There’s the trade-off. You and I can believe either of two things. We can’t really know for sure which choice is right.

The logic of Pascal’s wager says you ask which belief, if wrong, results in a worst outcome.

Recognizing Different Perspectives

A related comment: Have you ever observed (or yourself participated in) a heated argument over some classic investing issue? Like, for example, how much risk to bear or whether the stock market returns look promising?

I wonder if Pascal’s wager sometimes explains the different points of view.

It seems very likely that your worst decision to be wrong about differs from my worst decision to be wrong about.

Someone just starting to invest, for example, faces a different situation than someone in retirement.

Someone with a little financial cushioning faces a different situation than someone with zero cushioning.

Someone with a generous defined benefit pension or Social Security benefits faces a different situation than someone living off of savings.

Very possibly, lots of this investing stuff is a lot more situational than some folks want to argue.

Other Resources You Might Find Interesting

I’ve got to get back to finishing up tax returns. But if you’re perplexed or worried about your investments, see if the logic of Pascal’s wager helps.

And let me also share these comments in closing.

Wikipedia, predictably, has a good biographical write-up on Pascal. (It’s available here.)

If any of the above resonates, you might want to look at the series we did on the idea of having a Retirement Plan B.

If you’d like another writer’s take on expected equity returns and what to do about them, peek at our discussion of research the well-known Boglehead Siamond did on the CAPE and withdrawal rates.

Finally, if you are at all intrigued by this idea of using Pascal’s wager to improve upon your investment decisions, Google or Bing using a search term like “Pascal’s wager investments.” You can find many interesting and actionable articles and essays on how and where Pascal’s wager provides insights.

The post Pascal’s Wager and Your Investment Portfolio appeared first on Evergreen Small Business.

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About Carol St. Amand

Carol St. Amand

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