Pascal’s Wager is a classic for those who want to argue about the existence of God, but now, according to Peter L. Bernstein, of the New York Times, we should be using it for financial risk calculations. Say what?
Bernstien starts out fine:
For example, the average annual inflation rate in the United States was only 1.4 percent from the end of 1954 to the end of 1965. But in 1965, who could have imagined that inflation would average nearly five times that rate over the next 15 years?
In short, our forecasts are wrong from time to time.
I might quibble a bit with the “time to time”, BTW…
That observation sounds like a platitude, but consider the kinds of questions it provokes. How will we deal with surprises — outcomes different from what we expect? What are the consequences of being wrong in our expectations? This is the point when risk management begins to live up to its real meaning. Risk means the chance of being wrong — not always in an adverse direction, but always in a direction different from what we expected.
Yes, yes. Risk is about what is not expected, and many financial fiasco’s have been the fault of or worsened by risk in a direction not considered. But then we get to the good stuff. What should we do about this? We should learn from Pascal’s Wager:
The key word is “consequences.” I learned this lesson many years ago from studying Blaise Pascal, a French mathematical genius in the 17th century who spelled out the laws of probability more clearly than anyone before him. This was a thunderclap of an insight that, for the first time, gave humanity a systematic way of thinking about the future.
Pascal was both a gambler and a religious zealot. One day he asked himself how he would handle a bet on whether “God is or God is not.” Reason could not answer. But, he said, we can choose between acting as though God is or acting as though God is not.
Suppose we bet that God is, and we lead a life of virtue and abstinence, and then the day of reckoning comes and we discover that there is no God. Well, life was still tolerable even if less fun than we might have liked. Here, the consequences of being wrong would be acceptable to most people.
Suppose, however, we bet that God is not, and lead a life of lust and sin, and then it turns out that God is. Now being wrong has put us into big trouble.
Which leads me to propose the new investment strategy, based on the brilliant guy with a triangle named after him. I call it Lacsap’s Wager:
Lacsap’s Wager by Dave Bacon
Lacsap was both a puritan and a religious moderate. One day he asked himself how he would handle how to invest for his retirement. Reason could not answer. But, he said, we can choose between two choices: invest the money for retirement or not invest the money for retirement.
Suppose we choose to not invest the money, and we lead a life of partying and hedonism, and then the day of reckoning comes and we discover that we’re old and can’t take care of ourselves. Well, life was still pretty damn fun and we can always go on the dole. Here, the consequences of being wrong would be acceptable to most people.
Suppose, however, we invest all of our money for retirement, and lead a life of thrift, and then it turns out that the entire financial world collapses. Now being wrong has put us into big trouble. We have both lost all of our money, and we didn’t get to enjoy it while we had it.
In all seriousness I agree with Bernstein that some narrow definitions of risk can lead to disaster. But I’m a little more skeptical that Pascal’s Wager will give me any deep insight into how to deal with this problem.