Pascal’s Wager and the Making of Prudent Decisions: Active versus Passive

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Pascal’s Wager and the Making of Prudent Decisions: Active versus Passive

Larry Swedroe Sep 01, 2015

Last week, we saw how Pascal’s Wager led us to the prudent choice involving whether to purchase various types of insurance. Today, we’ll take a look at a few additional examples, beginning with the decision between purchasing Treasury Inflation-Protected Securities (TIPS) or nominal bonds.

TIPS versus Nominal Bonds

If you hold long-term nominal bonds, you win if deflation shows up, or even if inflation is less than expected. You lose, however, if inflation ends up being greater than expected, because your portfolio might not provide sufficient income for maintaining your desired lifestyle in retirement.

On the other hand, with TIPS, you win either way. If inflation does show up, the return on your bonds will keep pace. Even with deflation, as long as you bought the TIPS without any accumulated inflation adjustment, they should do at least as well as inflation because TIPS mature at par. Per the logic behind Pascal’s Wager, the consequences of your decision should dominate the probability of outcomes, making TIPS the prudent choice in most cases.

Active versus Passive Funds

If you buy an index or other passively managed fund, it should provide the market rate of return, minus expenses (which typically are very low). Alternatively, if you buy an active fund, you do have the small possibility of market-beating performance, but you also must accept the risk of below-average performance.

Given that investors are risk averse and the pain of a loss is much greater than the joy of an equivalent gain, Pascal’s Wager leads the way to a prudent decision: Become a passive investor.

Helping with this decision is the weight of academic, peer-reviewed research, which shows both that the majority of active funds underperform and that there’s no persistence of outperformance beyond the randomly expected.

Studies have also found the few funds that manage to beat their benchmark, on average, do so by a relatively small amount. On the other hand, funds that underperform do so, on average, by much larger amounts. One study, which covered the 10-year period from 1982 through 1991, found that because the few outperforming funds tended to beat their benchmarks by small amounts while the underperforming funds (a large majority) tended to miss by much wider margins, the risk-adjusted odds of outperforming an appropriate benchmark on an after-tax basis was 38 to 1.

The Ownership of Company Stock

Every investor knows that putting too many eggs in one basket is a risky investment decision, one that can easily be avoided by building a diversified portfolio. Still, many executives and long-term corporate employees end up with a substantial portion of their assets in the stock of the employer. I’ve seen numerous cases where employees have as much as 80 percent to 90 percent of their net worth tied up in their employer’s stock. Pascal can help us decide if this is a prudent decision.

Consider two outcomes. The first is one in which the company does well. If that’s the case, the employee will also likely do well, regardless of whether or not s/he owns lots of company stock. The outlook would be bright for pay increases, bonuses, promotions and even more stock options or stock grants.
On the other hand, if the company does poorly, the employee could face a case of double jeopardy. Not only will the portfolio take a devastating hit, but the employee may find themselves without a job due to layoffs or even bankruptcy. The consequences of decisions should dominate the probability of outcomes.

There are many other examples of how Pascal’s Wager can help us make prudent financial decisions. For example, in the current low interest rate environment, investors seeking incremental cash flow may decide to take more credit risk than they would normally.

Pascal would say that’s a bad idea because it takes an awful lot of interest to make up for unpaid principal. Or, those same investors might decide to extend bond maturities longer than they would normally to earn a term premium. But doing so takes on increased inflation risk.

The Bottom Line

I have been managing or advising on the management of financial risks of various kinds (such as interest rate, credit, foreign exchange, investments and insurance) for more than 40 years. Having Pascal “whispering in my ear” has prevented me from making a lot of mistakes, and helped me prevent others from making what could have turned out to be devastating errors on an order of magnitude that sometimes can be impossible to recover from.

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