For every decision we make, there is a possibility of some upside and downside risk. Take for example the decision to eat that yummy cake. Well, the downside risk is clogged arteries and heart attack perhaps. Or may be there is an increased chance of becoming diabetic. These are all long term risks right? So who cares. What about the upside? Well you get to enjoy the food and put your mind in a blissful state and you are in good mood perhaps for the rest of day at best. The upside is really short term. Now the question is whether I should have the cake or not. How do we go about it? One way is to consider the short term and long term consequences. But is so hard to visualize something that will happen far into the future. Why can’t I enjoy now? May be I won’t live that long to see the ill effects of my actions. That is one aspect of risk.

Another aspect of risk could be the probability of the event happening. Lets say, for me the risk of heart attack or diabetes is low because of my health and genetics. No one in my family had these problems although they have eaten similar amount of sugar. So then my probability of risk has come down quite significantly. Why should I give up on enjoying the sugary treat if the risk is low while the upside potential is high? This is one more way to think about risk of actions.

What about another aspect of risk, namely the consequence. However small the probability of some bad event happening due to my actions and no matter how long it will take, there is the consequence aspect. If the consequence of an action is death, then is the risk worth it? It is like playing the russian roulette. This also reminds me of the Pascal’s wager which helps us in deciding which way to go not just based on the probability of a risk but the consequences too.

Pascal argues that a rational person should live as though God exists and seek to believe in God. If God does not exist, such a person will have only a finite loss (some pleasures, luxury, etc.), whereas if God does exist, he stands to receive infinite gains (as represented by eternity in Heaven) and avoid infinite losses (an eternity in Hell).

So basically these are the possibilities

Sinful Pleasures God exists Outcome
Yes Yes Infinite loss (hell)
Yes No Finite gain (enjoyed without consequences)
No Yes Infinite gain (heaven)
No No Finite loss (could have enjoyed without consequences)

If you look at the matrix, you can understand that the loss is limited if the god does not exist and you did not take advantage of it. But the loss is infinite if you indulge in sinful but pleasurable activities and god does exist. So Pascal proposes that you might live as if god exists. While I disagree with the postulate it has some usefulness to it. By the way, this does not change my belief in god in anyway and I am still an atheist, so yeah I am probably going to hell :). I rather not believe in god and try not indulge in sinful activity instead of believing, sinning and trying to erase the ill effects by worshiping god or by confessing or by other means. Sorry I digress.

The reason I said it is useful is because now we have a way to choose whether to take an action not just based on probabilities but also on the consequences. This also applies to investing. Lets say you are presented with an investment opportunity with a very high probability of doubling your money but also an almost 0% chance of losing all your investment. What would you do. If you are investing for an important goal like children’s education or retirement, you should not take the risk because while the downside probability is very low, should it occur, it could wipe out your entire investment. So not just the probability, or long term vs short term but the consequence also matters.