© 2020 Arizent. All rights reserved.

Lessons on risk from, yes, a 17th century French philosopher

Register now

It’s time your clients met French philosopher Blaise Pascal. An actual meeting would be difficult to arrange because Pascal died in 1662. But his legacy includes an insight that should be central to the way we think about financial risk.

Pascal argued that it was rational to believe in God. If we believe in God and it turns out God doesn’t exist, the cost is modest – a little less immorality and an hour or two each week given over to worship. But if we don’t believe and it turns out God does exist, the price is considerably higher – an eternity roasting in hell. The implication: Even if the odds that something will happen are small, we should still pay attention to that slim possibility if the potential consequences are dire.

Pascal’s Wager, as it’s known, should figure into a host of financial decisions that advisers and their clients make, especially when it comes to investments and insurance.

You might ask clients to think about their investment strategy in three dimensions. First, there’s the ratio of stocks to more conservative investments. Second, there’s the number of stocks owned, whether through funds or by purchasing shares of individual companies. Third, there’s the variety of market sectors and countries represented by those stocks.

Obviously, a portfolio is riskier if it has a larger allocation to stocks, includes less individual companies, and has exposure to fewer market sectors and fewer countries. But at some point, if a portfolio’s focus gets too narrow, that risk morphs from mildly reckless to potentially ruinous.

This isn’t just a danger for those who bank heavily on one or two stocks, which could follow the unfortunate path taken by Enron, WorldCom, Bear Stearns, Lehman Brothers, etc. It’s also a risk for those with portfolios that appear to be more diversified.

If your clients are overweighted in tech stocks but otherwise own a fairly balanced portfolio, they will occasionally have a bad year, but they are still likely to earn decent returns over time.

For instance, if your clients are overweighted in tech stocks but otherwise own a fairly balanced portfolio, they will occasionally have a bad year, but they are still likely to earn decent returns over time. But if your clients own only tech stocks – even 50 or 100 tech stocks – they could suffer losses that set them back financially by 10 or 20 years, thereby wrecking their chances of a comfortable retirement.

Sound improbable? It certainly seemed that way in the late 1990s, when tech stocks were all the rage. But while the chances of financial disaster seemed slim at the time, the consequences proved devastating: Those who were fully invested in tech at the March 2000 peak lost a staggering 78% over the next 31 months, as measured by the Nasdaq Composite Index. The Nasdaq didn’t return to its 2000 peak until 2015 – fully 15 years later.

If betting on a single market sector is risky, betting on a single country can be even more perilous. Imagine your clients insist on sticking exclusively with U.S. stocks. Keeping all their stock market money at home might sound like a safe bet. But Japanese investors who took that tack at year-end 1989 would likely beg to differ. At the time, Japan was arguably the world’s most-admired economy. More than a quarter century later, an investor who owned only Japanese stocks would have less than half the wealth they had in 1989, based on the performance of the Nikkei 225 stock index.

Just as a lopsided asset allocation, coupled with poor diversification, can wreck a client’s financial future, there’s also great risk in failing to buy the right insurance. State law forces us to buy auto insurance, federal law compels us to purchase health care coverage and our mortgage company insists we buy homeowner’s insurance.

But nobody forces us to purchase life, disability, long-term care and umbrella-liability insurance. Clients may be primed to buy these policies if, say, they know a mother or father of young children who died suddenly or they had a parent who needed years of nursing home care.

But in the absence of personal experiences like that, many clients may feel like the risk is low – and that this is yet another example of insurance companies scaring folks into buying costly insurance policies they don’t really need.

First, establish your credibility by talking to your clients about who doesn’t need these policies.

What to do? You might take a three-pronged approach. First, establish your credibility by talking to your clients about who doesn’t need these policies, so it’s clear you don’t push everybody to buy great heaps of insurance. For instance, you might explain that clients don’t need life insurance if they’re single and don’t have anybody who depends on them financially. Clients likely also don’t need life insurance if, say, they have $1 million in investable assets, because their family should be okay financially.

A portfolio of $1 million in investable assets would probably also allow clients to self-insure for disability and long-term care. Meanwhile, the opposite logic applies to umbrella-liability insurance: Coverage probably isn’t necessary for families with few assets, because plaintiffs will quickly discover they aren’t worth suing.

Instead, coverage becomes more necessary as clients grow wealthier and hence become a more tempting target for the litigious. You might garner additional credibility with clients by explaining how clients can cut premiums by, say, extending the elimination period on their long-term care and disability insurance.

Second, talk about other clients whose financial lives were saved by having the right insurance coverage. Sure, you might mention statistics about how many folks end up in nursing homes or suffer a disability. But when it comes to persuading clients, statistics aren’t nearly as powerful as a few well-told anecdotes.

Finally, talk about the consequences. How would clients cope financially if the main breadwinner died or suffered a disability? What would your clients do if one member of a couple needed nursing home care?

Failure is not an option.

You might wrap all of this into a larger philosophical point: Managing money isn’t about amassing as much wealth as possible. Rather, it’s about having enough to lead the life we want. Rolling the investment dice, while saving money by skimping on insurance, may give us a shot at amassing more wealth. But with that chance of greater success comes a risk of devastating failure.

Those two outcomes are far from equal: We all get just one opportunity to travel from here to retirement – and failure is not an option.

For reprint and licensing requests for this article, click here.