Pascal's Wager: focus more on the CONSEQUENCES of being wrong than on the PROBABILITIES of being right

 Section 10: In the face of uncertainty, remember Pascal's Wager.

Elaboration of Section 10

This section introduces a powerful philosophical and risk-management concept that guides decision-making under conditions of inevitable uncertainty. It argues that in investing, where the future is fundamentally unknowable, you should focus more on the consequences of being wrong than on the probabilities of being right.

1. The Origin: Pascal's Wager
The core idea is borrowed from the 17th-century philosopher Blaise Pascal. His famous wager concerned the existence of God:

• If you believe in God and He exists, you gain infinite reward (heaven).

• If you believe in God and He doesn't exist, you lose a finite amount (some worldly pleasures).

• If you don't believe in God and He exists, you suffer an infinite loss (hell).

• If you don't believe and He doesn't exist, you gain a finite amount (worldly pleasures).

Pascal argued that the rational choice is to believe, because the potential downside of being wrong (infinite loss) is so catastrophic that it outweighs any high probability of God not existing. The consequences dominate the probabilities.

2. Application to Investing: The Intelligent Investor's Wager
The section applies this logic directly to investing. Benjamin Graham's version of this wager is as follows:

• The Certainty: The probability of making at least one significant mistake over your investing lifetime is virtually 100%. No analyst, no matter how skilled, gets every call right.

• The Wager:

  • Wrong Side of the Wager: An investor who is certain of their analysis and puts all their money into a single, "sure thing" (like the dot-com stocks in 1999) is ignoring the consequences of being wrong. If their analysis is flawed, the consequence is catastrophic, permanent loss of capital.

  • Right Side of the Wager: An intelligent investor who acknowledges their fallibility builds a margin of safety into every purchase and maintains a permanently diversified portfolio. This ensures that even if some of their analyses are wrong, the consequences are never catastrophic. A single mistake will not ruin them.

3. Practical Implications for the Investor
This philosophy translates into concrete, defensive actions:

• Always Demand a Margin of Safety: By buying a stock only when it is priced significantly below your calculated intrinsic value, you build a buffer that protects you if your earnings projections are too optimistic or if the market sours.

• Never Stop Diversifying: Holding a variety of uncorrelated assets (as discussed in Sections 3, 9, and 11) ensures that a disaster in one company or sector does not sink your entire portfolio.

• Avoid Chasing "Sure Things": The wager is a direct warning against flinging money at "Mr. Market's latest, craziest fashions" like IPOs, hot sectors, or stocks touted as having a 100% chance of success.

4. The Psychological Benefit: "This, too, shall pass away."
Adopting this mindset provides emotional fortitude. When a holding performs poorly or the entire market crashes, the investor who is properly diversified and who bought with a margin of safety can remain calm. They know that no single event can destroy them, and they have the confidence to say, "This, too, shall pass away," and wait for the recovery.

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Summary of Section 10

Section 10 argues that since the future is uncertain and mistakes are inevitable, the intelligent investor must prioritize protecting against the consequences of being wrong over chasing the probabilities of being right.

• Core Concept: The philosophy of Pascal's Wager teaches that when faced with uncertainty, one should choose the path that leads to the least catastrophic outcome if one's judgment is wrong.

• Investment Application: The probability of making an investing mistake is 100%. Therefore, the intelligent investor's primary goal is to ensure that no single mistake can be catastrophic.

• The Strategy: This is achieved through two key principles:

  1. Margin of Safety: Always buying at a significant discount to intrinsic value.

  2. Diversification: Never concentrating your portfolio in a single bet.

• The Outcome: This defensive posture allows an investor to withstand market volatility and their own analytical errors, ensuring they survive to participate in the long-term upward trend of the markets.

In essence, this section is about humility and prudence. It teaches that successful investing is less about being a brilliant forecaster and more about being a brilliant risk-manager who always has a backup plan

The Dale Carnegie Principle on worry.

Learn to apply the Dale Carnegie Principle on worry.

When we have to take decisions we worry about the consequences.

Before running away, ask yourself what is the worst that can happen if you take the decision.  

Analyse the facts and the situations; it may not be as bad as you think.

Be prepared for the worst, then go ahead and take the decision.

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