Pascal's Wager Applied to Financial Markets

Pascal's Wager Applied to Financial Markets

October 10, 2019

Originally posted July 24, 2019


Hello Friends,

Welcome to Summer. This weekend should continue our streak of 90-degree weather after a cool and wet Spring. The stock market has been heating up as well, with the S & P 500 up over 20% year to date after losing just over 4% last year. This strong performance, which caps off a ten-year period of 14 % + annualized returns, naturally has people wondering if the end is near and a bear market imminent.

Allow us please to reframe the discussion for a moment. Blaise Pascal, a French mathematician and theologian who died over 350 years ago, did some of his most groundbreaking work in the areas of probability theory and decision making. In short, Pascal posited that when reason cannot determine the truth between two options, one must “wager” by weighing the possible consequences.

Pascal’s “wager” was originally conceived as an argument as to whether God exists. Pascal argues that a rational person should live as though God exists and seek to believe in God. If God does not actually exist, such a person will have only a finite loss (some pleasures, etc.), whereas he stands to receive infinite gains (as represented by eternity in Heaven) and avoid infinite losses (eternity in Hell).[1]

Extending Pascal’s “wager” to investing, one might ask, “How much will additional gains in the market benefit me versus how detrimental would a large loss be at my stage of life?” A portfolio in distribution should be designed more conservatively than one which is not being drawn down. Similarly, a portfolio with only a few years left until distribution needs to be less aggressive than one with many years until the first withdrawal.

“Bear Markets” are generally defined as a period where the stock market goes down 20% or more. Statistically, they occur about 1 out of every 3.5 years. Understanding that corrections (drops of 10%) and “Bear Markets” will occur with some frequency and without any way to time their arrival or duration requires investors to adjust their portfolios for their time fame, need for distributions, and tolerance for volatility. Those who will need to withdraw money over the next one to five years should consider de-risking their investments in favor of income producing assets.

Pascal would ask, “What if I’m wrong?” In his decision- making process. If you believe that this “Bull Market” will continue, you would do well to ask yourself the same question. What are the consequences if I’m wrong? If you are wrong and the market goes down by 20% or more will it affect your ability to retire, to pay your bills, to pay tuition, or even to sleep at night? If so, you should start rebalancing now. Viewing the market’s return in terms of “what are my needs going forward” rather than “can the stock market rally continue” will help you rationalize your investment strategy. We can help you personalize your portfolio for your own needs for income and liquidity.

We look forward to talking with you about it.

All Our Best,

Michael Roberts Associates

Certain sections of this commentary contain forward-looking statements that are based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. All indices are unmanaged and are not available for direct investment by the public. Past performance is not indicative of future results. The S&P 500 is based on the average performance of the 500 industrial stocks monitored by Standard & Poor’s.

[1]Blaise Pascal ,Wikipedia, 6/26/2019