Finding God in Behavioral Finance

"Belief is a wise wager.  Granted that faith cannot be proved, what harm will come to you if you gamble on its truth and it proves false?  If you gain, you gain all; if you lose, you lose nothing.  Wager, then, without hesitation, that He exists." ~ Blaise Pascal (1623-1662)

Undoubtedly, the ultimate lesson in minimizing risk and maximizing return was put forth by this French mathematician nearly four centuries ago.  Pascal's Wager underscores, quite effectively, the human folly of not prudently measuring the consequences of our choices in relation to their potential outcome.  What does this "gambit" regarding religious faith have to do with investing?  More than you may think...

A recent article in Financial Planning magazine titled, Bet On Longevity, draws an interesting parallel between Pascal's Wager and the commonly overlooked risk of outliving your money in retirement:

...the consequences of not believing are more severe than the consequences of believing.  If you're wrong, you lose nothing; if you're right you win everything...

...with today's expanding life expectancies, the reality is that the client might live to age 90 or beyond.  The consequences of not having properly prepared his or her finances could be depending on children or even applying for welfare...

The point of Pascal's Wager is that the consequences of a choice may be far more important than the likelihood of its outcome...

What if you live longer than you "planned?"  If you "bet on longevity" and die sooner, you "lose" nothing.  If you live longer and fail to invest accordingly, you face the most unfavorable outcome...    The consequence of choice (running out of money) outweighs the likelihood of the potential outcome (living longer), especially if market risk is properly understood... 

Ultimately, personal finance is all about risk management, which, in turn, is about reducing the likelihood of an unfavorable outcome, which results in an unfavorable consequence (loss of value).  I've touched on this before, most directly in my post, Know Thy Risk, but understanding risk is the first and most prudent step in managing it. As humans, we are not wired to be investors.  We seek patterns (i.e. movement of stock prices) and assume they will continue by applying them to the future.  This worked well for the caveman in finding food and avoiding predators but is perilous for the investor of today... 

Pascal's Wager lends itself to an analysis of risk behavior, especially where an investor tends to misunderstand the difference between risk and uncertainty. As is my common practice, I defer to wisdom that already exists, whenever possible, to clearly communicate complex concepts.  Here are a few choice excerpts from one of my favorite pieces on risk and uncertainty:

Typically, in situations of choice, risk and uncertainty both apply.  Many situations of choice are unprecedented, and uncertainty about the underlying relation between cause and effect abounds...

Given that risk is quantifiable, it is more accessible to theoretical and empirical treatment than is uncertainty.  It is thus not surprising that academic literature on stock market randomness deals exclusively with stock market risk.  On the other hand, ignorance of uncertainty may be hazardous to the investor's financial health, as the rise and fall of Long-Term Capital Management illustrates...

Although risk is quantifiable, uncertainty is not.  Rather uncertainty arises from imperfect knowledge about the way the world behaves.  Most importantly, uncertainty relates to the questions of how to deal with the unprecedented, and whether the world will behave tomorrow the way it behaved in the past.

Of course, after this piece was written, another "quant fund" failure, similar to Long Term Capital Management, occurred.  All too often, investors miscalculate risk by making investment choices based upon patterns that rely on outcomes that are unknowable.  This behavior actually increases the likelihood, as time passes, that outcomes will be unfavorable, especially due to the initial illusion that the "pattern" appears to be producing a favorable outcome.  Of course, this potentially destructive behavior is compounded by complacency and greed but that is another post... 

It's important to understand, in terms of personal finance, that there are many different kinds of risk.  Most would agree that the undesirable outcome of risk is loss -- a decline in value, usually in an unexpectedly or relatively unpredictable manner.  It's also important to understand that we may "calculate" risk in terms of probability of an outcome, such as with rolling a pair of dice.  Uncertainty, however, is a state of mind, typified by lack of sureness about something and is highly subjective and, therefore, not quantifiable.  Risk and uncertainty may influence each other but they are not one in the same... 

Let's tie some things together with some simple examples using Pascal's Wager as a backdrop:

• Whether or not there is a God:  Uncertainty
• The way you lead your life:  Choice / Risk
• God's existence or non-existence:  Outcome
• Heaven or Hell:  Consequence

Now, applied to investing:

• The future price of a given investment:  Uncertainty
• The way you invest (strategy / allocation):  Choice / Risk
• Future investment price / investment performance:  Outcome
• Gain or Loss:  Consequence

While Pascal's Wager certainly draws a compelling illustration of choice, consequence, outcome, and the relative investment concepts of risk and uncertainty, some may still argue that religious "faith" is not an investment strategy.  Once again, I'll defer to words better expressed than mine (from Pascal), and allow you to draw your own correlations:

"Faith certainly tells us what the senses do not, but not the contrary of what they see; it is above, not against them."

"The supreme function of reason is to show man that some things are beyond reason."

"All men's miseries derive from not being able to sit in a quiet room alone."

I make a conscious effort not to push my values on to others and I will not do that now; however, I will provide testimony that being a person of faith, for me, goes beyond religion for religion's sake, which would be shallow and dishonest.  I find that faith, rather, enhances all areas of my life, which includes investing.  Faith reminds me that I am small, yet I can "be the change that I want to see in the world;" that, no matter how compelling an argument may sound, reason can not provide answers to absolutely unknowable questions; that the desire for answers often impedes our understanding of the questions to begin with; that humans are flawed; that moderation is wise; that we must be comfortable within ourselves; that meditation (prayer) has the power to lift burdens; and that there is more to life than money...

Comments

[Cavemanus]

Thank you so much for this thought provoking post.

In one example you state:
"[It is] important to understand that we may "calculate" risk in terms of probability of an outcome, such as with rolling a pair of dice."

But, if I could add to your dice analogy:
"When a die rolls off of the table, the event was unquantifiable and, therefore, an uncertain outcome."

Rolling a die is quantifiable risk, you can calculate the probabilities. There is still uncertainty involved in the process, though. It is important when investing to be aware of both factors.

As far as your religious beliefs, you note the existence of God is an uncertainty. You clearly feels it is a yes or no question ("He" exists, or not). You have faith, and spirituality is a very personal issue. I certainly would never try to alter your beliefs, but I will suggest reflection on the following:

Uncertainty dictates that there are other options you may not have considered. Perhaps there is higher consciousness without the necessity of a personified deity. Perhaps there exists a universal consciousness. I do not know, of course, but I think the options are limitless beyond comprehension.

The point of uncertainty is that the risk you try to control may turn out to be moot. That does not mean you make drastic changes to the way you live or stop trying to control risk. It simply means you never stop considering the possibilities you may have overlooked.

Thanks again for making me think!

[The Financial Philosopher]

Cavemanus:

Excellent points! Regarding your comment "When a die rolls off of the table, the event was unquantifiable and, therefore, an uncertain outcome."

I will not argue with that point but will add to it by returning to the variable of "choice" from my post: The die-roller made a choice to roll them on the table. Making a choice to roll them on the floor, instead, will completely remove the uncertainty that a die will roll off the table...

As far as your comment that "Uncertainty dictates that there are other options you may not have considered. Perhaps there is higher consciousness without the necessity of a personified deity. Perhaps there exists a universal consciousness. I do not know, of course, but I think the options are limitless beyond comprehension."

I believe humans have the need to attach a name or meaning to things they can not comprehend, such as a "personified deity." Your "higher consciousness" and "universal consciousness" sound attributable to Godly characteristics to me. I will agree that it may be wise to consider beyond the absolutes of God exists or does not exist. Perhaps, instead, it is wiser to decide there is a God but spend our energy defining what that means to us personally rather than allow others to define it for us...

On a much lighter note, the post referred to retirement. To end on a personal finance analogy, we should also define what that means personally -- otherwise, we are left with what others will define -- age 65, stop working, get Social Security, play Golf, watch the grass grow, wait to die. That's not my definition...

Thanks again for the thought provoking points...

[Rachael]

Thanks for the information...I bookmarked your site, and I appreciate your time and effort to make your blog a success!

[Evan]

Great post. My thoughts are similar.

http://evanbleker.com/thoughts-on-risk/

I used to think that the best investment strategy, or the one that produces the best returns, is the one that is best able to minimize risk. I'm not sure about that anymore, though. If that were the case than just putting your money in a savings account pegged to inflation would be the best investment strategy (so long as you're not counting opportunity cost as risk). To make decent money requires risk-taking, though maybe the best strategy in a given asset class is the one that has the least amount of risk.

When it comes to stocks, what investment strategy do you think best deals with risk and has the largest potential reward?

[Kent @ The Financial Philosopher]

Evan:

The answer to questions of investment strategy application for an individual always begins with "it depends."

Personally, I believe there is risk in not taking enough risk. At a minimum, I expect my money to be worth more later than it is now. In other words, if I can outpace inflation after taxes and trading costs, I am happy.

I also do not like to spend a large amount of time analyzing investments.

Considering all that I have said, I like to use a mix of around 8 mutual funds and ETF's that are most passive (Index). I use a "core and satellite" approach with around 30% in large cap index and the remainder in a combination of small-cap, emerging markets, multi-sector bond and a few sector funds with near-term growth potential.

My approach is really quite simple, although it may sound somewhat complex.

Thanks for the comment.