Blaise Pascal, the brilliant seventeenth-century French philosopher and mathematician, became a devout Christian in his later years. As one of the original probability theorists, he rationally explained the pious life using mathematics rather than simple faith. He argued that if heaven and hell exist as discrete outcomes in the afterlife and that the probability of each was arbitrarily assigned to be 50 percent, one must still choose the virtuous lifeHis rationale rested on the difference in the severity of the outcomes: He reasoned that an eternity of heavenly bliss was infinitely preferable to one of never-ending damnation. That, in a nutshell, is Pascal’s Wager.[1]

Pascal’s Wager has broad applicability in the world of economics and finance:

In testimony before Congress during the second half of 2003, Alan Greenspan added a new wrinkle to his macroeconomic management formula that looks a lot like “Pascal’s Wager.” In justifying maintaining the discount rate at the 1 percent level, he admitted that he would rather err on the side of being too easy than too tight, because the consequences of the latter are much more dire than the former. Thus, even though he assigns a relatively low probability to the deflationary scenario, its consequences are so grave as to cause him to “overweight” that possibility in his policy calculus.[2]

In this scenario, the probabilities of deflation over inflation were likely less than a 50/50 split, but the pain of the former was presumed so intense that Greenspan preferred to endure the difficulties of an economy weighted toward inflation. Ben Bernanke was similarly conditioned against deflation as the Great Depression of the 1930s was the principal subject of his 1979 doctoral dissertation.

Whether the fears of these central bankers were rational or not, we can only speculate. The common thread woven through both positions is that of asymmetry. Of the two outcomes, deflation is, their thinking goes, asymmetrically destructive relative to inflation.

How To Wager On The Future

The antithesis of a central banker, Nassim Taleb deals with asymmetry at length and discusses managing a portfolio in an asymmetrical environment. He argues that investments should position you to take advantage of relatively infrequent but asymmetrical events. That is, should a negative outcome occur, you should have a greater exposure to favorable results than unfavorable ones.

Further, by definition, the unknown is unknowable. We are not, for instance, taking sides in the inflation/deflation debate. That does not prevent investors, however, from hypothesizing about asymmetrical outcomes that might result from either eventuality, thus making investment decisions that seek the safe side of such situations.[3]

Like Greenspan and Bernanke, Taleb understands (at a much deeper level) that the idea behind Pascal’s Wager has fundamental applications beyond religion.

It stands the entire notion of knowledge on its head. It eliminates the need for us to understand the probabilities of a rare event (there are fundamental limits to our knowledge of these); rather, we can focus on the payoff and benefits of an event if it takes place. The probabilities of very rare events are not computable; the effect of an event on us is considerably easier to ascertain (the rarer the event, the fuzzier the odds). We can have a clear idea of the consequences of an event, even if we do not know how likely it is to occur. I don’t know the odds of an earthquake, but I can imagine how San Francisco might be affected by one. This idea that in order to make a decision you need to focus on the consequences (which you can know) rather than the probability (which you can’t know) is the central idea of uncertainty. Much of my life is based on it.

Pascal’s Wager has figured prominently in my overall approach to decision making whenever the pendulum of risk has swung to either extreme. The immediate challenge is to mitigate the consequences of bad, but unpredictable, outcomes. For those whose portfolios are exposed to what could be acute market risk, the odds of which none of us can fully compute, all one has to do is buy insurance—or get out and invest the amounts one is not willing to ever lose in less risky securities. As you will read next, there have been times when the arc of the pendulum begs you to accept risk precisely because the favorable consequences so conspicuously outweigh the unfavorable.

And When To Wager

Those of us investing our own assets, as well as those of others, in the early 1980s[4] experienced a time of immense opportunity—in Taleb’s parlance, a virtuous Black Swan. Amid two back-to-back recessions with inflation and interest rates (long and short) in the mid-teens, the S&P 500 dividend yield often over 6%, and the P/E ratio (based on latest 12-month earnings, as well as the CAPE), ranging from 7 to 9 times, opportunity beckoned. In August 1982, the S&P was 20% below the high it had achieved almost 10 years earlier.

Fast-forward to today. The second-longest U.S. economic expansion on record is still under way and will capture first place in July 2019, if it outlasts the 120-month expansion of the 1990s. CPI inflation is averaging 2%, and the 2- and 10-year Treasury yields are in near proximity to 3%. The S&P 500 dividend yield is under 2%, and the P/E ratio is 25 times trailing 12-month earnings and 33 times the CAPE. If the S&P is trading at current levels by early March 2019, it will have risen fourfold since the lows 10 years ago.

This environment is just as surely to cause those inconsiderate of history to overestimate the opportunities ahead, just as the seemingly desolate backdrop in the early 1980s led investors to underestimate the market’s potential. Today’s Black Swan might be described posthumously as ominous, the antithesis of the virtuous characterization in the early 1980s. To be sure, the financial crisis and the ensuing recession were real and painful. Because policymakers ardently believed that they had arrived at a Pascal moment, fiscal and monetary policy were applied in a desperate attempt to truncate the downside. The evidence continues to accumulate that the excesses, instead of being purged, have grown only more menacing to financial and economic stability. The open question remains: Did the authorities, in the name of expediency, fear or, perhaps something even more threatening, vainly seek to forestall a 100-year flood by plugging the dike instead of rebuilding the levee?

In my view, this is the moment for Pascal’s Wager. The unfavorable consequences possible today so outweigh the favorable ones that it is prudent to seek safe haven from the unpredictable but virtually inevitable punishment of a harrowing downward revaluation of equities. In the vainglory and hubris courtesy of our nearsighted vision, we often forget this maxim: “In the end we are being driven by history, all the while thinking that we are doing the driving.”[5]



[1] Frank K. Martin, A Decade of Delusions (Wiley, 2011).

[2] Ibid.

[3] Nassim Nicholas Taleb. The Black Swan: Second Edition: The Impact of the Highly Improbable Fragility (Kindle Location 4626). Random House, Inc. Kindle Edition.

[4] From early 1979 through September 1982.

[5] Taleb, Ibid.


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