Blaise Pascal, the 17th Century mathematician and philosopher mused about the existence of God and came up with what is now known as Pascal’s wager. Given that you cannot determine whether God exists through reason, Pascal tried to define whether a person would be better off living life as though God existed or not. He concluded the wise decision is to wager that God exists, because if He does, you gain eternal life, but if not, you will be no worse off in death than if you had not believed. Pascal’s wager is not a proof, it is merely a conclusion to the possibilities where one is deciding under uncertainty.
The relevance of this largely philosophical debate to investing may seem tenuous. However I think there are a number of parallels that can be drawn between the two.
In the same was as Pascal mused about the existence of God, investors face a similar wager in the consideration of their investments. Consider the following:
In the face of uncertainty — like the performance of capital markets — it makes sense to consider the consequences of being wrong. If you gamble on the future and guess correctly you will do extremely well and likely end up exceptionally wealthy. If you guess incorrectly you will end up impoverished. If however, you accept the reality of uncertainty in capital markets and take a more measured approach, you will end up comfortably wealthy whether you guess right or wrong.
The goal in investing should not be simply to get rich, rather it should be - for want of better wording - not to become poor. We can choose to guess which way the markets are going and go all-in, or we can choose to adopt a longer-term, balanced approach. There are two lessons here for investors.
Accommodating uncertainty in your portfolio is an argument for a diversified asset allocation strategy. All-in bets on any single outcome are a fast-track to the poor house. They are wonderful until they stop working. An argument in favour of diversification is seemingly uncontroversial, yet it is something I find needs constant reinforcement. I’ll stop short of reiterating the case for diversification again here, but you will find it is a constant theme in most of what I write.
The second lesson relates to attempts to divine the future in order to identify the precise way to allocate a portfolio to maximise returns. Investors (both professional and otherwise) spend an inordinate amount of time trying to forecast, despite the evidence to suggest that it is a complete waste of time. Strategic diversification is built around the principle of proofing your portfolio for different scenarios. You don’t need to predict where markets are going, just prepare for the inevitable swings and ideally take advantage of them.
There will always be some people for whom the possible downside of being very poor is outweighed by the possible upside of being very rich. Though I suspect the majority of investors would feel this poverty gamble isn't worth the risk, it is never quite that simple.
Pascal’s Wager is firmly rooted in the philosophical tradition of rational argument. In the face of a roaring bull market rational thinking becomes distorted. As Warren Buffett once opined, “Nothing sedates rationality like large doses of effortless money”. It’s not easy to sit on your hands and decide to ignore apparent easy riches.
Investment decision making is an inevitably an emotional process. Capital markets function as a constant mechanism for challenging convictions and staying resolute when those convictions look misplaced is difficult. As investors we need tools to ground our thinking in the inevitable situation where we find our choices being challenged.
Advice is absolutely critical. Even if you are a seasoned investor, having someone to use as a sounding board or to offer opinion will prove invaluable. At the very minimum you should define broad guidelines for the investment portfolio along with clear restrictions. You need to place clear limits on the allocation to different assets, documenting of investment goals and clarifying the rationale for decisions taken.
Pascal had his share of critics. Agnostics argued that the right thing to do is not to wager at all. Pascal’s response was this, "But you must wager. There is no choice. You are already committed." His point was that we are not outside observers of life, but participants. Similarly, with respect to investing. We are all participants, even if only committing money to deposit. Don’t be agnostic, unless it’s in respect of stock market predictions.