Blaise Pascal was a 17th century French mathematician, physicist, inventor, writer and Christian philosopher. He made an argument about the existence of God, which is generally called “Pascal’s Wager“:
Humans all bet with their lives either that God exists or that he does not. A rational person should live as though God exists and seek to believe in God.
If a person believes in God, and He does exist, such a person will have only a finite loss (some pleasures, luxury, etc.), whereas they stand to receive infinite gains (eternity in Heaven) and avoid infinite losses (eternity in Hell).
If a person doesn’t believe in God, and He does exist, such a person will suffer in Hell.
So, this is the summary table to decide, whether to believe in God or not:
But, Pascal’s Wager should not be seen just as an argument in Christian philosophy. It is much more profound, applicable in life and investing. It’s about decision theory.
Warren Buffett said this about climate change, in the 2015 annual report of Berkshire Hathaway:
It seems highly likely to me that climate change poses a major problem for the planet. I say “highly likely” rather than “certain” because I have no scientific aptitude and remember well the dire predictions of most “experts” about Y2K. It would be foolish, however, for me or anyone to demand 100% proof of huge forthcoming damage to
the world if that outcome seemed at all possible and if prompt action had even a small chance of thwarting the danger.
This issue bears a similarity to Pascal’s Wager on the Existence of God. Pascal, it may be recalled, argued that if there were only a tiny probability that God truly existed, it made sense to behave as if He did because the rewards could be infinite whereas the lack of belief risked eternal misery. Likewise, if there is only a 1% chance the planet is heading toward a truly major disaster and delay means passing a point of no return, inaction now is foolhardy. Call this Noah’s Law: If an ark may be essential for survival, begin building it today, no matter how cloudless the skies appear.
To generalize, Pascal’s Wager goes like this:
We should always consider the consequences of ‘being wrong‘, even if its probability is very low. This is most important when the losses from ‘being wrong‘ are extremely huge.
Say, you believe that one of your friends have done a big mistake. You accuse him publicly about that violation. Have you thought: “what if, I am wrong in the accusation?”
What if, he was innocent? You did an irreparable damage to his reputation. You lost your friend forever.
So, what should you do, if you believe that your friend did a mistake? Just go and speak to him about it. I know, I’m not offering a conclusive solution here, but I’m just trying to avoid the regrettable consequences of being wrong.
When you consider various investment options, the key question you need to ask is:
What if, I am wrong?
This will force you to think in ways you have never imagined.
There are three major areas in investing, where Pascal’s wager is helpful:
- How much to invest in equities?
- To diversify, or to concentrate?
- To invest, or not to invest in a company?
Let’s look at each of them:
1. How much to invest in equities?
You should always think about Pascal’s wager, when deciding how much to invest in riskier assets like equities. Equity is risk capital. Equity shareholders are the last in the queue to get money, when a company goes bankrupt. Equity is not just “risky”, it is the “riskiest” form of financial investment. So, how much of your savings should you put in this “riskiest” asset?
Don’t put at risk, anything more than what you are willing to lose completely.
If you have $100,000 of total wealth, and believe that you need $90,000 to have a comfortable retirement, don’t put anything more than $10,000 at risk.
William Bernstein believes that investors should avoid the worst-case scenario of running out of money. He says:
When you have won the game, you stop playing. If you have acquired enough assets to retire on by staying in safe assets, then the only money that you should be putting at risk in stocks is the money you don’t need.
2. To diversify, or to concentrate?
Pascal’s wager can also be thought of as a justification for having a diversified portfolio. If you concentrate your investments too much, say 20% in each stock (meaning just 5 stocks in the portfolio), the consequence of being wrong in just one of these investments can be pretty huge. That being said, I favor concentrated investing, but do not believe in investing more than 10% in a single stock.
3. To invest, or not to invest in a company?
While investing in a particular stock, ask yourself: “what if, I am wrong?”. What if, the assumptions – based on which you arrived at an intrinsic value – just go wrong? We’re screwed, aren’t we?
When investing in equities, people like us consider only the UPSIDE. We never give a thought about the DOWNSIDE.
Pascal’s wager forces us to think through both consequences of a decision – upside and downside.
Next time you take a decision – be it in life, investing or any other scenario – ask yourself:
“What if, I am wrong?”
Wikipedia: Pascal’s Wager
Berkshire Hathaway: 2015 Annual Report
William Bernstein: Investing to Avoid the Consequences of Being Wrong