Pascal's Wager and the Making of Prudent Decisions: Asset Allocation

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Heads or Tails coin flip


Pascal's Wager and the Making of Prudent Decisions: Asset Allocation

Larry Swedroe Aug 20, 2015

As financial author William Bernstein points out, the crux of the wager is this: “If a supreme being doesn’t exist, then all the devout has lost is the opportunity to fornicate, imbibe, and skip a lot of dull church services. But if God does exist, then the atheist roasts eternally in Hell.”

Asset Allocation

While it is indeed likely that a higher allocation to risky assets will result in greater wealth, that outcome isn’t even close to a certainty. In addition, not only do we know that for most people the pain of a loss is at least twice the magnitude of the positive feelings generated by an equivalent gain, but the larger the amount involved, the greater that ratio becomes. While you might be willing to risk $100 to win $200 on the flip of a coin, most people would require much better odds if the stakes were raised to, say, $1 million, and even higher odds if the wager was $10 million.

As Pascal demonstrated, there are some risks that are just not worth taking. This was a lesson the market taught many investors in 2008.

I asked the couple if, instead of falling almost 80% their portfolio had doubled to $26 million, would that gain have led to any meaningful change in the quality of their lives? The response was a definitive no. I stated that the experience of watching $13 million shrink to $3 million must have been very painful, and they probably spent many sleepless nights worrying. They agreed.

I then asked why they had taken the risks they did, knowing the potential benefit was not going to change their lives very much but a negative outcome (like the one they experienced) would be so painful. The wife turned to the husband and punched him, exclaiming, “I told you so!”

The Bottom Line

Next week, we will look at how considering Pascal’s Wager can help you make additional prudent financial decisions.

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