Your probability of being right and your consequences of being wrong: Understanding Pascal's Wager

Before you invest, you must ensure:

• that you have realistically assessed your probability of being right and
• how you will react to the consequences of being wrong.

The investment philosopher Peter Bernstein has another way of summing this up. He reaches back to Blaise Pascal, the great French mathematician and theologian (1623-1662), who created a thought experiment in which an agnostic must gamble on whether or not God exists.

• The ante this person must put up for the wager is his conduct in this life; the ultimate payoff in the gamble is the fate of his soul in the afterlife.
• In this wager, Pascal asserts, "reason cannot decide" the probability of God's existence.
• Either God exists or He does not - and only faith, no reason, can answer that question.
• But while the probabilities in Pascal's wager are a toss-up, the consequences are perfectly clear and utterly certain.

As Bernstein explains:

Suppose you act as though God is and you lead a life of virtue and abstinence, when in fact ther is no god. You will have passed up some goodies in life, but there will be rewards as well. Now suppose you act as though God is not and spend a life of sin, selfishness, and lust when in fact God is. You may have had fun and thrills during the relatively brief duration of your lifetime, but when the day of judgment rolls around you are in big trouble.



Concludes Bernstein: "In making decisions under conditions of uncertainty, the consequences must dominate the probabilities. We never know the future."



Thus, as Graham has reminded you in every chapter of his book, the intelligent investor must focus not just on getting the analysis right. You must also ensure against loss if your analysis turns out to be wrong - as even the best analyses will be at least some of the time.

• The probability of making at least one mistake at some point in your investing lifetime is virtually 100%, and those odds are entirely out of your control.
• However, you do have control over the consequences of being wrong.
• Many "investors" put essentially all of their money into dot-com stocks in 1999; an online survey of 1,338 Americans by Money Magazine in 1999 found that nearly one-tenth of them had at least 85% of their money in Internet stocks.
• By ignoring Graham's call for a margin of safety, these people took the wrong side of Pascal's wager.
• Certain that they knew the probabilities of being right, they did nothing to protect themselves against the consequences of being wrong.

Simply by keeping your holdings permanently diversified and refusing to fling money at Mr. Market's latest, craziest fashions, you can ensure that the consequences of your mistakes will never be catastrophic.

No matter what Mr. Market throws at you, you will always be able to say, with a quiet confidence, "This, too, shall pass away."



Ref: cc Intelligent Investor by Benjamin Graham