Red-Blooded Risk: The Secret History of Wall Street

CHAPTER 3

Pascal's Wager and the Seven Principles of Risk Management

The modern study of risk began with an eccentric example. A series of letters between the great French mathematicians Blaise Pascal and Pierre Fermat in 1654 considered some mathematical problems related to bets on dice throws. Dice represent a very unusual kind of risk. We know for certain all possible outcomes and their associated probabilities. We can gain no useful information to predict the throw, nor to influence it. The first is by assumption, the second by rule; neither one is physically true. The result of a dice throw is unambiguous, and everyone learns it at the same time. You can search the entire natural and human world and find zero examples that resemble this kind of risk, except gambling games and controlled scientific experiments that are designed for the purpose of creating the risk. Even in gambling, the model Pascal and Fermat analyzed is only an approximation: unexpected outcomes occur, dice can be loaded, people cheat, and results are disputed. Only in the abstract play world, isolated from the real world, do the mathematical results hold.

Blaise Pascal created another work about risk that is almost as famous, but gets less attention from serious researchers in risk. It is known as Pascal's wager. He began by considering whether God existed and concluded there was no way to answer the question by reasoning. Therefore, you have to make a bet. If you bet that God exists and you are correct, ...