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Pascal’s Wager, the Stock Market, and Disparate Returns on Blind Faith

Real Investment Advice  ( Original )
JUN 14, 2018

Pascal’s Wager is the best of philosophy, wit, and critical thought: “If God exists, belief would lead to infinite joy in heaven, while disbelief would lead to infinite damnation in hell. But, if God doesn’t exist, belief would have a finite cost, and disbelief would only have at best a finite benefit.” Therefore, one should act as if God is real, no matter what they think.

This is a small but powerful bit of logic. If one reasons that the maximum benefit of not believing in God is some degree more latitude in terms of one’s moral behavior while alive on Earth, but the maximum penalty for not believing in God is eternal damnation and suffering in hell, that’s a pretty powerful argument for “I might as well act as if there is a God, even if I think there isn’t. Because the other side of that trade is among the all-time worst risk/rewards there are.”

Inviolate belief that the stock market offers higher returns than any alternative investments over time, no matter what, is dangerous. Not necessarily ‘eternal damnation’ dangerous, but still.

And especially so as an investor gets closer to retirement age. The simple fact of the matter is that if you start investing when you’re 21 and are looking at a 50-year investment timeline, you can afford not to worry about when the market will crash next.

But given how often the market does crash, if the bottom happens to fall out when you’re close to retiring, the idea that the market will probably recoup those losses over the next 20 years does you no good whatsoever. And at best, as the chart below illustrates, it’s a crapshoot over the short term.

The “power of compounding” ONLY WORKS when you do not lose money. After three straight years of 10% returns, a drawdown of just 10% cuts the average annual compound growth rate by 50%. Furthermore, it then requires a 30% return to regain the average rate of return required. In reality, chasing returns is much less important to your long-term investment success than most believe.

The problem with following Wall Street’s advice to be “all in – all the time” is that eventually you are going to dealt a bad hand. By being aggressive, and chasing market returns on the way up, the higher the market goes the greater the risk that is being built into the portfolio. Most investors routinely take on more “risk” than they realize which exposes them to greater damage when markets go through a reversion process.

ORIGINAL SOURCE: Pascal’s Wager Shows Why Stocks Get More “Risky” Over Time by Lance Roberts at Real Investment Advice on 6/14/18