Enrich Your Future 27: Pascal’s Wager: Betting on Consequences Over Probabilities

Andrew Stotz 00:02
Andrew, fellow risk takers, this is your worst podcast host, Andrew Stotz from a Stotz Academy, continuing my discussion with Larry swedroe, who for three decades was the head of Research at Buckingham wealth partners. You can learn more about his story in episode 645, now, Larry stands out because he bridges both the academic research world and practical investing. And today we're diving into a chapter from his recent book, enrich your future, the keys to successful investing. And we're going to be talking about chapter 27 which is Pascal's Wager, the making of prudent decisions. But before we do some of you may say, Well, who is this dude? Pascal. Let me tell you. Blaise Pascal was born in 1623, he was a brilliant mathematician, physicist and philosopher, and by the age of 19, he had invented one of the world's first mechanical calculators. His work in mathematics helped shape probability theory, which is now the foundation of modern statistics and risk analysis in the world of finance and in physics, he discovered Pascal's law, which explains how pressure is transmitted through fluids, something still used in hydraulic systems today. Later in life, he turned to philosophy and religion, and we're going to be talking briefly about that. And he wrote the Ponce, a collection of thoughts about faith and reason. But what I liked was Pascal was also known for his wit and clarity in writing. In one of his letters, he famously apologized for writing a long message saying I didn't have time to make it shorter, his words remind us that simplicity often takes the most amount of effort. Larry, take it away. Yeah,

Larry Swedroe 01:47
thanks. And I in my own writing, I'll often just sit down to write, get the thoughts out, and then I focus on making it shorter. What words can I take out without negatively impacting the piece. So I'm following his advice. It does. It is harder to write shorter.

Andrew Stotz 02:06
Yeah, and that's what you're doing in so many of the posts that I see of what you're writing in your articles is that you're trying to take a very complex, you know, situation and bring it down to something that people can understand. So you definitely have that in action.

Larry Swedroe 02:19
Well, thank you. So Blais Cal Pascal posed this interesting question which will not will relate to financial theory, financial management, etc, but we need this story or analogy to help people understand the financial side of the picture. So Pascal asked the question, how should you act when we cannot prove or disprove if God exists, it's a belief one way or the other. You can't prove there is a God, and you can't prove there isn't one. So how should you act? So Pascal put it this way. He said, If a Supreme Being doesn't exist, then all the devout has lost is the opportunity to fornicate, imbibe and skip a lot of adult church services. But if God does exist, then the atheist rose in hell for eternity, at least if you believe, as the Catholics do so that what he's really telling people here, and this is what relates to finance and financial planning in general, is it's the consequences of your actions that matter far more than whatever you Think the probabilities of the outcomes might be so great example is how we think about buying life insurance. So let's imagine you're an average 28 year old. You got married a few years ago, have your first child, and you have to decide whether you should have life insurance or not. Well, 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 over the next 40 years. Yet, most people buy the insurance because the consequences of their being wrong, and they happen to be unlucky enough to die, either through some accident or some disease that wasn't forecasted for them, then their wife and children may be living in poverty and they that's just a consequence that's not acceptable. And then you can relate the same thing with people buying long term care insurance or disability insurance or homeowners. Insurance to protect you against a fire if you happen to live in LA or a hurricane, if you happen to live in Florida, or a monsoon, if you happen to live in Thailand, all right, so we think about what's the cost of the left tail outcome happening? And if it's greater than you could bear, that's why insurance markets are created. I'll give one last example, which is one of the biggest mistakes that investors make. I find but work for a company and own their company stock, especially senior executives. In some cases they're even expected to own large shares, but they're often incented. Employees are given sometimes a 10% discount to buy the stock, and they end up with very large positions more than I think no one should own more than about 10% of their net worth in any individual security, because you're taking idiosyncratic risk, and your company could turn out to be the next Enron or the next hertz or the next digital equipment or Kodak or Polaroid, all one's great is

Speaker 1 06:15
that why they call It idiot Synchron What did you call it

Larry Swedroe 06:20
idiosyncratic? Yeah, idiot, syncretic risk. That's very clever anyway. So you know, no matter how much you think a company is likely to do great and you're a senior executive of the company, I think we may have talked about the case. There was once an executive I met in the late 90s. Worked at Intel, and he had about a $13 million net worth. Almost all of it was an Intel stock. And I pointed out to him the examples of once great companies that no longer even existed virtually or stock prices had crashed over 90% like Polaroid and Kodak and digital equipment and Data General and Oxford computing, which was the first lap, you know, carryable computer, I mean, mass, great innovators, and they were gone, right? And yet he was absolutely convinced. So nothing go wrong. And by the way, if it did, he would know before it happened. And the stock, which was trading at the time at 60, within a matter of months, was down to like 10, and went even a bit lower, and has never recovered, you know. And now we're almost 30 years later, and yet, you know, the cost of his being wrong meant he would still be okay. So he had 3 million instead of 13 or something like that, but his life would have been a lot better, and he would have been able to leave a nice, big estate for his children as well. It just made no sense, because doubling his 13 to 26 which might have happened if Intel did great wouldn't have changed his life in any way close to the magnitude of the negative impact of going from 13 down to three. So that's another example where of teaching Pascal's Wager and understanding the consequences of the decision should dramatically overweight, whatever you think the odds of that event happening.

Andrew Stotz 08:25
And I just had our monthly meeting at my coffee business, coffee works in Bangkok, where I went through our monthly results, which we do at the end of each month or middle of the following month. And we had a discussion about our risks. You know that we see outstanding in the business, and we looked at the probability of those risks happening, in the severity of those risks, and then we apply a score, and we have a discussion about it, and debate the score, the score there, but it's a type of thing that we're pretty used to doing, let's say, in the corporate world. But when it comes to, you know, investing, people seem to put it all aside. I Why do you think that people just kind of put it aside when they're thinking about investing, whereas they'll go to their office and apply that risk management structure in their business or in the company that they work for? Why do they just throw it away? Yeah,

Larry Swedroe 09:17
I would suggest the likelihood is overconfidence. Number one, they think they can forecast what's going to happen better, like that Intel executive, or it's not going to happen to me, that only happens to other people, or it's so unlikely that I don't have to consider the event. And unfortunately, we have events. We've had two of them in the US recently of airplane crashes, which is the safest by far a form of transportation in the United States, you're more likely to die walking across the street in Manhattan and getting hit by a car than by dying in a plane crash. And yet, hopefully, the. People who needed life insurance, you know, and passed away, and those tragic events happened to have it and then weren't overconfident about their likelihood of not having such event.

Andrew Stotz 10:14
I thought about what you said, about how you know, it's kind of like Every dog has its day. Every stock, every big stock, eventually comes down at some point. But you know, I was doing some research, talking to my students in one of my classes about building a business that has longevity, and you find that there's a very small number of companies in this world that do have longevity, which is just you could never predict it at the time. For instance, Procter and Gamble was founded in 1837 and that means it's been in existence for 187 years, and it's been listed in the stock market for 134 so don't think that your stock selection wisdom is so great that you're going to pick the next Proctor and Gamble or Exxon Mobil, that's been in existence in one former number from Standard Oil since 918 70 right, and has been listed for 104 years. Or how about the really obscure company, Northwest natural holding, which is a utility company, which was founded in 1859 and is now 165 years old and 54 years listed on the stock market. So just because we do have some long lasting companies doesn't mean that the ones you picked are going to be long lasting. Well,

Larry Swedroe 11:30
I think we've discussed this before a couple of times, only 4% of all the stocks on the US stock exchanges account for 100% of the equity risk premium. That's because most companies eventually disappear. You know, there's only one company that was in the original Dow Jones that still even exists. Yeah, it's

Andrew Stotz 11:56
incredible. I mean, it's an important point when you're thinking about not only building a portfolio, but building a company. You know, what does it mean to build a company? To last also, you mentioned in this chapter two

Larry Swedroe 12:07
other issues that I discuss in the book related to Pascal's Wager. And this is, should you buy? At least in the US? I don't know in other countries, you may not always have that opportunity, but is available in some whether you buy a nominal interest rate bond, like a US Treasury, or you buy what's called a treasury inflation protected security, or tips, so you're guaranteed to earn the inflation rate plus a rate or a real rate of return. Well, you know, that's a question, what if inflation looks like it did in, you know, Germany in the 1920s or ends up looking like Argentina in the last century, many times over, or Brazil today, right? So you could say, well, I'm getting a higher nominal yield by buying the nominal bond, or I'm even getting a higher expected return, based upon your view of inflation. But what's the cost of that? You might be wrong. In other words, people should be willing to give up some thing, even of significance in terms of the expected return to protect against that last that terrorist. And the other example is this issue, should you invest in active or passively managed funds? Well, the odds are so great, only roughly 2% today of active managers outperform and when they do this, few percent that do outperform tend to outperform by a little bit much less than the ones that underperform underperform by so you have to think about what's the cost of being wrong versus giving up on that hope, or The ability to brag how you pick the best performing stock. I think Pascal's Wager gives you the right way to think about the answer. And then, by the way, you get to enjoy your life much more, because you don't have to look at the stock market, try to pick stocks, follow companies, and waste all that time doing it when it's highly likely to prove unproductive, actually counterproductive. Anyway. Actually,

Andrew Stotz 14:25
it's an interesting one about the tips, because one of the things many countries do not have tips or but what's interesting is I'm going to share my screen and just show some statistics that I look at, and just hold on one second. So here's some statistics. I actually calculate a world inflation, and I do that by taking the inflation rate of all the countries in the world that have consistent inflation data, and then GDP weighted right weighted by the size of the. That economy. And then I hear in this chart show it compared to the US. And what you can see is that even though your country may not have a tips bond buying a US, tips bond may actually perform a portion of the function, because inflation globally tends to track inflation in the US or vice versa. Do you have any thoughts on that?

Larry Swedroe 15:24
Yeah, you know, it's probably at least worth considering depending upon the country, although never treat the unlikely as impossible. If I lived in Switzerland, I'd worry a lot less about it. But you know, if you live in Thailand, you know, the odds are, you know, favor much more likely that if there's an inflation problem, it would be more likely to happen in Thailand, which would weaken their currency, and therefore you would get that benefit, and you would get a real return in the US market, and if US inflation turned out to be high, well at least you'd have the inflation rate going up, which should offset, in theory, the dollar depreciation. So I think that's at least worth considering in most countries, especially where you have that currency risk because the balance of payments problems, profligate governments, historical devaluations of their currencies, like Argentina or Brazil, those kind of countries, just keep our repeat offenders. So I would never have faith in those countries ability control and fight at least you want to make sure that you are protected or have that insurance.

Andrew Stotz 16:45
Yeah. Well, this is a great discussion. I appreciate it particularly. You know, thinking about, you could say, extreme outcomes and helping, helping us all to think that we need to protect against extreme outcomes, and we also need to have avoid overconfidence and thinking those extreme outcomes aren't going to happen to us and for for the for the listeners and the viewers, I also want to, you know, highlight that when you're writing, stop and rewrite and print it out. Look at it. You know, my father always said, Write what you want to write, then print it out and read it, and then rewrite it, and then rewrite it. And I do that pretty much religiously on every single thing I write. And it's shocking how comfortable I am with what I wrote the first time. But when I print it out and I read it as the reader, I'm like, Ah, there's so much I gotta fix here. And I don't know you go through that process, or how is your possibility 100%

Larry Swedroe 17:41
of the time, and just coincidentally, last night, I was asked to help my granddaughter, who's 14. She had to write some paper, and she asked me to help her, and she's at the top of her class in one of the top private schools in the area. Her grade point average is close to 100 and, you know, all her subjects so, and she writes beautifully. And so I basically didn't correct anything virtually. There was minor stuff, but we went through it, and we must have cut out about 40 words. Many of the adjectives like very interesting. Well, it's either interesting or it's not. You don't need to, or you could say, in other words, why do you need? In other words, so we cut out about 40 of the word, and he and I just asked her. I said, Ruby, which words can you cut out of this sentence? And she would find them. I said, Whenever you can cut them out. Do. So that's

Andrew Stotz 18:40
exactly my father went to a private school called Shadyside Academy, and then he went to Cornell for his undergrad. And he went to Cornell partially because of Richard Feynman and his interest in science, and maybe the smartest man who ever lived, yeah, and, and eventually, Richard

Larry Swedroe 18:58
Feynman, and by the way, everyone should read his book.

Andrew Stotz 19:02
Yeah. I mean, all of his books are amazing in the wonder of finding things out, I think it's called and the joy of finding things out. But what I remember is Strunk and what is, what is, what is, the Elements of Style, and we had to study that in class for English. And that was, you know, my dad has, I still have his copy of the elements of style of writing, but my dad always talked about trying to reduce words. It's funny that you mentioned that because, and then he also said, Use more simple words wherever possible. And one of the most agree egregious offenses is utilize. And I simply cannot find a case where you should use utilize instead of use. I can't find it, but everybody likes to use the word utilize. So the for the listeners and viewers out there, keep your writing simple and clean and people. Love reading it. So that's the last thing I would say. Anything you would add.

Larry Swedroe 20:03
No, I think that's a good way to end it. Yep, irregardless of anything else, that's my favorite pet peeve, because there is no such word, and I hear it all the time. Yes, we'll

Andrew Stotz 20:15
scratch that then. So that was a great discussion. I appreciate it. And we're going to go into chapter 28 next, which will be buy, hold or sell, and the endowment effect. And I'm looking forward to that one for listeners out there who want to keep up with all that Larry's doing, following on x at Larry swedroe And also on LinkedIn. This is your worst podcast host, Andrew Stotz, saying, I will see you on the upside.