In this episode of Enrich Your Future, Andrew and Larry Swedroe discuss Larry’s new book, Enrich Your Future: The Keys to Successful Investing. In this series, they discuss Chapter 27: Pascal’s Wager and the Making of Prudent Decisions.

LEARNING: Use Pascal’s wager to avoid making devastating mistakes.

 

“You have to think about the cost of being wrong versus giving up on that hope or the ability to brag about how you pick the best-performing stock. Pascal’s wager gives you the right way to think about the answer. And then, you get to enjoy your life much more.”Larry Swedroe

 

In this episode of Enrich Your Future, Andrew and Larry Swedroe discuss Larry’s new book, Enrich Your Future: The Keys to Successful Investing. The book is a collection of stories that Larry has developed over 30 years as the head of financial and economic research at Buckingham Wealth Partners to help investors. You can learn more about Larry’s Worst Investment Ever story on Ep645: Beware of Idiosyncratic Risks.

Larry deeply understands the world of academic research and investing, especially risk. Today, Andrew and Larry discuss Chapter 27: Pascal’s Wager and the Making of Prudent Decisions.

Chapter 27: Pascal’s Wager and the Making of Prudent Decisions

In this chapter, Larry discusses Pascal’s wager, a suggestion posed by the French philosopher Blaise Pascal that emphasizes the importance of considering the consequences of decisions rather than just the probability of outcomes.

Pascal’s wager

In Pascal’s wager, the philosopher asked how we should act when we cannot prove or disprove if God exists. To answer this question, the philosopher said: if a Supreme Being doesn’t exist, then all the devout have lost is the opportunity to fornicate, imbibe, and skip a lot of adult church services. But if God does exist, then the atheist roasts in hell for eternity.

Pascal concluded that the consequences of your actions matter far more than whatever you think the probabilities of the outcomes might be.

Using Pascal’s wager to make financial decisions

Pascal’s wager empowers individuals to make informed financial decisions. It encourages us to carefully consider the consequences before accepting the risks involved in case we are wrong. This approach can be applied to a wide range of financial decisions, instilling confidence in our choices.

Buying life insurance

Imagine you’re an average 28-year-old. You got married a few years ago and have your first child. Now, you must decide whether you should have life insurance. If you buy the life insurance, you know with a very high degree of certainty for the next 40 years, you’re going to be paying away a premium to the life insurance company and foregoing their earnings that you could get by taking that money investing in the stock market and maybe get a seven to 10% per annum return.

Yet, most people buy the insurance because of the consequences of their being wrong, and they happen to be unlucky enough to die, either through an accident or some disease that wasn’t forecasted for them. Then, their wives and children may live in poverty. And that’s just a consequence that’s not acceptable.

Asset allocation

In another example, Pascal discusses someone who has already achieved sufficient wealth to support a quality lifestyle. Should they focus on preserving capital by allocating a low amount to risky assets like equities or try to accumulate even more wealth by allocating a significant amount to risky assets?

To decide on which side of Pascal’s wager this individual wants to be with their portfolio, Larry advises to consider this insight from author Nassim Nicholas Taleb: “One cannot judge a performance in any given field by the results but by the costs of the alternative (i.e., if history played out differently).

Long-term care insurance

Larry also examines how Pascal’s wager can help us decide whether to purchase long-term care insurance. According to Larry, say a couple, both 65 years old, has a portfolio that is highly likely to provide sufficient assets to maintain their desired lifestyle if neither ever needs long-term care. If one or both need long-term care for an extended period, the portfolio will likely be strained or depleted.

If no insurance is needed, the costs of purchasing a long-term care policy increase the odds of running out of money by just 3% (from 94% to 91%). On the other hand, if long-term care is needed and no insurance is purchased, the odds of running out of money increase by 20%—the odds of success fall from 94% to 74%.

That is almost seven times the 3% increase in the likelihood of failure caused by the purchase of insurance. It seems clear that the purchase of the insurance is a prudent decision.

Purchasing TIPS or nominal bonds

Another decision investors should use Pascal’s wager to make is whether to purchase TIPS or nominal bonds. According to Larry, 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 is greater than expected because your portfolio might not provide sufficient income to maintain your desired lifestyle.

On the other hand, with TIPS, you win either way. If inflation shows up, the return of your bonds keeps pace. Even with deflation, they do at least as well as in inflation because TIPS mature at par.

The consequences of your decision should dominate the probability of outcomes, making TIPS the prudent choice in most cases.

Let Pascal whisper in your ear

In conclusion, Larry encourages investors to use Pascal’s wager to avoid making devastating mistakes that are sometimes impossible to recover from.

Further reading

1. Jonathan Clements, “The Little Book of Main Street Money,” Wiley, 2009.
2. Nassim Nicholas Taleb, “Fooled by Randomness,” W. W. Norton & Company, 2001.

Did you miss out on the previous chapters? Check them out:Part I: How Markets Work: How Security Prices are Determined and Why It’s So Difficult to Outperform

• Enrich Your Future 01: The Determinants of the Risk and Return of Stocks and Bonds
• Enrich Your Future 02: How Markets Set Prices
• Enrich Your Future 03: Persistence of Performance: Athletes Versus Investment Managers
• Enrich Your Future 04: Why Is Persistent Outperformance So Hard to Find?
• Enrich Your Future 05: Great Companies Do Not Make High-Return Investments
• Enrich Your Future 06: Market Efficiency and the Case of Pete Rose
• Enrich Your Future 07: The Value of Security Analysis
• Enrich Your Future 08: High Economic Growth Doesn’t Always Mean High Stock Market Return
• Enrich Your Future 09: The Fed Model and the Money Illusion

Part II: Strategic Portfolio Decisions

• Enrich Your Future 10: You Won’t Beat the Market Even the Best Funds Don’t
• Enrich Your Future 11: Long-Term Outperformance Is Not Always Evidence of Skill
• Enrich Your Future 12: When Confronted With a Loser’s Game Do Not Play
• Enrich Your Future 13: Past Performance Is Not a Predictor of Future Performance
• Enrich Your Future 14: Stocks Are Risky No Matter How Long the Horizon
• Enrich Your Future 15: Individual Stocks Are Riskier Than You Believe
• Enrich Your Future 16: The Estimated Return Is Not Inevitable
• Enrich Your Future 17: Take a Portfolio Approach to Your Investments
• Enrich Your Future 18: Build a Portfolio That Can Withstand the Black Swans
• Enrich Your Future 19: The Gold Illusion: Why Investing in Gold May Not Be Safe
• Enrich Your Future 20: Passive Investing Is the Key to Prudent Wealth Management

Part III: Behavioral Finance: We Have Met the Enemy and He Is Us

• Enrich Your Future 21: Think You Can Beat the Market? Think Again
• Enrich Your Future 22: Some Risks Are Not Worth Taking
• Enrich Your Future 23: Seeing Through the Frame: Making Better Investment Decisions
• Enrich Your Future 24: Why Smart People Do Dumb Things
• Enrich Your Future 25: Stock Crashes Happen—Be Prepared
• Enrich Your Future 26: Should You Invest Now or Spread It Out?

About Larry Swedroe

Larry Swedroe was head of financial and economic research at Buckingham Wealth Partners. Since joining the firm in 1996, Larry has spent his time, talent, and energy educating investors on the benefits of evidence-based investing with an enthusiasm few can match.

Larry was among the first authors to publish a book that explained the science of investing in layman’s terms, “The Only Guide to a Winning Investment Strategy You’ll Ever Need.” He has authored or co-authored 18 books.

Larry’s dedication to helping others has made him a sought-after national speaker. He has made appearances on national television on various outlets.

Larry is a prolific writer, regularly contributing to multiple outlets, including AlphaArchitect, Advisor Perspectives, and Wealth Management.

 

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