Insurance is one of those things you buy but aren’t always sure why you buy it. Just seems like the thing to do, adult life on auto-pilot. As a result many people buy insurance they don’t need while skimping on the insurance they do need. So, let’s take a look at what it’s for and from there figure out what to buy.
There are two elements to consider when evaluating insuring against something: probability and consequence. In a sense, a neutral insurance premium is the product of these two things, what is the probability of something happening times what is the financial consequence if it does happen. This is a calculation you can always estimate in your head if considering a premium as cheap or expensive. People insure against all kinds of things, but your focus should be on the things with low probability but high consequences.
Fundamentally, insurance is for really BIG expenses you MIGHT have in your life, that otherwise would be impossible to afford. Let’s remember that every time you are faced with an insurance decision. It’s not for small expenses. It’s not for things that are guaranteed to happen. We’re looking for the big maybes. So….your house might burn down, you might crash your car and hurt yourself or someone else, you might get a life threatening expensive disease, you might die tomorrow leaving your family with no income (if you’re the main bead-winner. Aside, where did we get the term bread winner? Bread earner, sure, but no one is entering some big bread lottery at the office every day). Therefore home, car, health, and life are the typical big 4. Notice things that aren’t in this category. Your TV might break outside it’s regular warranty, or your car might need a minor repair. “Extended warranties” are parts of insurance in this category. They are small, and by definition a bad deal for the average person. Recall one of the first parts of your investment portfolio is your rainy day fund, this should take care of this small stuff.
Here’s why. Insurance is a for-profit industry. The rates are set such that the average person will pay more in premiums then will get out in benefits. Notice, this is for the average person, some people will indeed get more then they put in, but on average, insurance is a money loser for the customer. We have insurance to protect against really big stuff that would cripple us financially. Don’t get me wrong, I like insurance, and have a lot of it. It’s role is to protect me against the small, but still possible financial disasters. Paying for that and recognizing the company is making a profit is reasonable. Paying for appliance repair, car repair, or other minor items is much cheaper paying with your savings or budgeted–in factor one of the main reasons for having savings in the first place.
I was buying my new Honda a little while ago and they couldn’t believe I wasn’t taking their extended warranty deal. “Even my mom gets this”. Well, your mom got ripped off, probably. It has to be this way. If it were truly a good deal for the consumer then on average Honda would be paying out more then they take in for the warranty premiums. They’d be losing money. Would any company really be giving you the hard sell for something where they’d lose money? Buy insurance only for things where the downside is truly unaffordable, and use your rainy day fund for the small stuff. In the end, you’ll come out richer.
Every investor in stocks should know, there will be days, months, even years where you lose money. It is part of the deal, higher average return in exchange for larger uncertainty of that return. We invest in stocks because generally over the long term they make more money than other available investments. But there is another concept to keep in mind on those down days; usually what is really driving the price on a short term basis is speculation about where a stock price is going, not investing in the company’s long term prospects of making profits and growing the company. Here’s an example. Suppose you have a bunch of small stuffed animals that your child likes. They have some intrinsic value–they entertain your little one for a few seconds. Parents, treasuring those few moments a day are willing to fork over $10 for them. Then something odd happens, for whatever reason there is a growing momentum among the population that these little stuffed toys are extremely valuable! People start bidding them up on eBay and some sell for $1000’s. (Note these reasons are extremely hard to predict, and you could argue its exactly what many financial professionals are trying to do). Suddenly, you’re rich! Junior’s toys are going to put him through college! Then later, people start to realize, wait, these are just toys. Their intrinsic value is simply their ability to entertain a child. Granted, on the right day a parent might pay $1000’s, but usually that’s a $10 value. Their value plummets right back down to what you paid for them, and you have lost $1000’s. But have you really? You never really had that money. All that happened is you owned something that a bunch of people were willing to pay insane amounts to get, but in the end you never “made” or “lost” any money at all. The intrinsic value of what you own (in the case of a stuffed animal, its ability to entertain or in the case of a stock, the company’s ability to generate profits) is exactly the same. You haven’t “gained” or “lost” anything!