Are the Rewards Worth the Risks?

Last Updated Jun 26, 2009 5:35 PM EDT

(Note: This is part three of a series regarding how your financial makeup should determine your investments. For other posts in the series, see the link at the bottom of the item.)

In the foreword to Jonathan Clements new book The Little Book of Main Street Money (which I highly recommend), my friend William Bernstein writes about Pascal's wager and how it relates to investing.

Pascal's wager is a suggestion posed by the French philosopher Blaise Pascal that even though the existence of God cannot be determined through reason, a person should wager as though God exists. The reason is because the consequences of being wrong with each belief are very different. As Bernstein points out: "If a supreme being doesn't exist, then all the devout has lost is the opportunity to fornicate, imbibe, and skip a lot of dull church services. But if God does exist, then the atheist roasts eternally in hell."

If you have already achieved sufficient wealth to support a quality lifestyle, you face a similar wager. You can focus on the preservation of capital by having a low allocation to risky assets, or you can try to accumulate even more wealth by having a large allocation to risky assets. While it is likely that a high allocation will result in greater wealth, you can be wrong. And the consequences of going from rich to poor are intolerable for most people.

The bottom line is that the consequences of decisions must always dominate the probabilities of outcomes. That is why the prudent strategy for investors that have reached the point where their marginal utility of incremental potential wealth is low is to have their portfolios be dominated by high-quality fixed income assets. There are some risks that are just not worth taking.

If you are deciding on which side of Pascal's wager you want to take with your portfolio, I recommend that you consider this important insight from author Nassim Nicholas Taleb, who stated in his wonderful book Fooled by Randomness:
One cannot judge a performance in any given field by the results, but by the costs of the alternative (i.e. if history played out in a different way). Such substitute courses of events are called alternative histories. Clearly the quality of a decision cannot be solely judged based on its outcome, but such a point seems to be voiced only by people who fail (those who succeed attribute their success to the quality of their decision).
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    Larry Swedroe is a principal and director of research for the BAM Alliance. He has authored or co-authored 12 books, including his most recent, Think, Act, and Invest Like Warren Buffett. His opinions and comments expressed on this site are his own and may not accurately reflect those of the firm.

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