Never Forget Pascal’s Wager

Should you believe in God?  More importantly, what the heck does that have to do with a family finance blog?  As it turns out, a lot.  Blaise Pascal was a French philosopher, mathematician, physicist, and inventor – basically the classic Renaissance Man.  He came up with what I believe to be one of the better driving philosophies for life.  Pascal developed what is now known as Pascal’s Wager, the idea that you should believe in God if only because the upside is so much greater than the downside.  His argument was simple and straightforward.  If God doesn’t exist, then the upside of not believing is limited.  At best, you gain a little extra time that would have otherwise been spent at church or in prayer and a few pleasures that you may have otherwise not have partaken in.  However, if God does exist, believing represents infinite gains (Heaven, or whatever eternal gains that brings) while not believing represents unlimited losses (Hell sure sounds like a crappy place to spend eternity).

As I’ve mentioned in previous posts, our family is not religious, but that doesn’t mean that I take no insights from Pascal’s Wager.  In fact, I believe it offers some of the greatest insights for living a rational life.  Pascal’s Wager was the precursor to subjects like game theory and concepts like Nassim Taleb’s antifragility and black swans (extreme events and our response to them).  These studies provide us with a path for making better decisions.  And in some cases, it points out the obvious – when the upside is unlimited and the downside is limited, or conversely when the downside is unlimited but the upside is limited, then taking steps to minimize the cost of the downside or maximize the upside, regardless of the likelihood, is a rational choice.  We are not observers in life so we must play the game.  In certain games, you have no choice but to wager, so make sure your bet is a smart one.

Finite versus Infinite

Nassim Taleb wrote: “One cannot judge a performance in any given field (war, politics, medicine, investments) by the results, but by the costs of the alternative (i.e. if history played out in a different way). Such substitute courses of events are called alternative histories. Clearly, the quality of a decision cannot be solely judged based on its outcome, but such a point seems to be voiced only by people who fail (those who succeed attribute their success to the quality of their decision).”  In effect, our decisions cannot be judged based solely on the outcome, but also on the potential alternative outcomes.  A bad outcome can also be the best outcome, if all other alternatives are much worse.

There are possible scenarios with odds that are extremely low, but where the downside is so extreme that they cannot be ignored.  These scenarios must be protected against – you must protect yourself from infinite losses when there are only finite costs.  For example, what if your spouse was dying from a rare disease but there was an unproven drug that had a small possibility of saving their life?  Wouldn’t you take it, even if the possibility was tiny?  After all, the alternative is that your spouse passes away without the chance for a cure.  Or what if your house was on fire and you weren’t sure if your children were in their bedrooms or not?  Would you not run into the house and try to save them, even if there was only a small possibility that they were in there?  The downsides in these situations are just too great to ignore.

These types of remote, but extreme events exist in broader society as well.  Take global warming.  There’s enough evidence to suggest it is happening and we humans are causing it, but let’s say you’re still not convinced.  Looked at another way, it doesn’t matter whether you believe the evidence or not – the consequences of doing nothing (starvation, mass migration, resource wars, etc.) are so great that doing something now, even when there’s a small cost, makes more sense than doing nothing.  Or how about big banks and high leverage?  While the upside to allowing them to exist and not regulating them is cheaper financial products (although marginally, and maybe not), the downside is so severe (2008-2009) that allowing them to get bigger with more leverage is foolish.  Or how about the trend towards overprotective and overscheduled parenting.  Overprotective parents hide their kids from the world, which in the long run prevents them from becoming mature and fully functioning adults.  The small costs along the way of allowing kids to make their own choices and their own mistakes (within reason) are limited, while the downside is a potentially dysfunctional adult who never grows up.

In these situations, it’s balancing the downside with the cost, and recognizing that sometimes a bad outcome is the best outcome.  If the downside outcome is extremely bad, even if it’s an unlikely possibility, and if the cost of insuring against it is small, then you should take the insurance.  Conversely, if there is much to be gained with a small and limited loss, why would you not pay for the option?

Pascal’s Wager in Your Personal Life

Pascal’s Wager impacts all of us beyond the societal level.  Thinking in terms of tradeoffs and alternative outcomes can help us make better decisions.  Let’s look at some of the ways we can use this line of thinking.

  1. Personal Finance & Investing: William Bernstein is one of the first personal finance authors to incorporate Pascal’s Wager into a financial context. Bernstein focused heavily on retirement planning and when to annuitize some of your nest egg and when to take on risk.  There are many other examples as well.
    • Saving or planning for the future: From a Pascal’s Wager standpoint, not saving or planning for the future makes no sense. Even if you don’t need the money, you will still be better off having it than not.  The tradeoffs are straight forward.  You give up marginally greater consumption today, but in exchange you gain living with a higher level of economic certainty in the future.  The downside from not having money is far greater than the downside of giving up some current consumption.
    • F-You money and Risk: Assuming you’ve worked hard and achieved F-You status, why continue to take major risk in your portfolio? After all, if you’ve already won the game, why keep playing?  Once you’ve reached F-You level, you must decide whether to keep investing in higher risk assets.  It may, and likely will, earn you more wealth in the future, but there’s always a risk that you lose your ability to choose whether to work again.  Going from rich to poor would be incredibly painful and almost unthinkable for many wealthy individuals.  Transitioning your F-You money from growth to capital preservation makes sense from a Pascal’s Wager standpoint.
    • Insurance: Living without basic life insurance if you have dependents, or not insuring your income-earning capabilities through disability insurance is foolish. Particularly when you’re young, dying or becoming disabled would have devastating consequences versus the limited cost of paying $1000 per year for insurance on both.
    • Investing: Investing is full of Pascal’s Wagers. We’ve already discussed creating optionality in your portfolio, which is all about finite downside with much higher upside.  But it goes beyond that.  Indexing is a form of trading off downside risk.  In this case, minimizing the chances of being wrong (e.g. picking the wrong stocks) relative to just happily earning the equity risk premium.  On the more active side, being short stocks is incredibly hard work – you have only a finite gain (100% if the stock goes to zero) versus the potential of an infinite loss.  Choosing to not short stocks is a perfectly logical decision.
  2. Personal and Family Life: People are rarely rational, so does applying a rational decision-making framework even make sense?  It can, and applying some game theory and Pascal’s Wager to your relationships can help everyone get along better.
    • Relationships: Game theory helps you put yourself in someone else’s shoes and think about the consequences of certain actions. Unless a relationship is truly poisonous, don’t cut it off.  Rather, put it in hibernation.  The downside is that you occasionally must deal with someone who’s difficult while the upside may be unlimited depending on how things go in the future.  You never know when someone may be able to lend a helping hand or change their attitude.
    • Dealing with the kids: There’s a great book out called the Game Theorist’s Guide to Parenting that offers several suggestions for helping kids get together better and make better decisions. For example, when having to divide something between several children, try the I Cut, You Pick method.  One child divvies up whatever needs to be split while the other child gets to pick their pile first.  Or the Tit for Tat method, where each child gets to choose their chores first, with the order shifting so everyone gets a chance to choose first.  For broader family decisions, such as what movie to watch or which restaurant to go to, you could use the Random Dictator method.  Everyone writes down their choice on a sheet of paper and one is randomly selected.  All of the above are equally fair (or equally unfair) to everyone involved.
  1. Your Career: Choosing a career with solid earnings prospects versus a “truer” version of your dream job is often the best decision. For example, let’s say you’re desperate to work in the social sciences, helping those struggling to get by.  You could go the purer route, working directly for a government or charitable organization, or you can choose a higher earning route.  Perhaps you can work in corporate responsibility or an employee assistance program at a Fortune 500 company, or as a Veteran’s Affairs officer (average salary $70,000), or even as a social science researcher.  The point is that if you accept a less “pure” dream job that still incorporates many of the positive elements you’re looking for, you can still do good work, while earning a solid living.

Remember that most dream jobs rarely are that – all jobs have some amount of crap attached to them.  People’s dreams change greatly over the course of their life.  Rarely does someone keep the same dream or passion for years without it changing in some form.  The only downside is having part of your work time involving your passion versus spending all of your time on your passion.  The upside is that you can earn a quality living and not struggle at low income jobs.

Don’t Forget Pascal’s Wager!

When making decisions, remember that alternative outcomes need to be considered, with the best choice sometimes being one with a cost attached to it.  A finite cost that either reduces an infinite unknown or allows for an infinite upside is often a wise one.  Pascal illustrated this when determining whether to believe in God.  You don’t have to get quite so deep.  Pascal’s Wager shows up in personal finance, your relationships with family and friends, and even in your career choice.  Recognize the value in using game theory and that the concepts of antifragility and black swans can lead to more rational outcomes for all of us.

Keep building my friends.

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