Retail Ninja Mind Trick #5: Value and Discounting Biases

We are notoriously bad at estimating the value of things in the future, especially in the distant future. Also: Anybody who's ever purchased an extended warranty should re-read this post twice.

Back in the 1800s when I was a wide-eyed finance student getting my MBA at Columbia University, we had a surprisingly cute economics professor who one day in class held up a check for $100. She told us that this check was dated one year in the future, and that she was selling this future-dated check to whichever student made the highest bid.

For a few minutes we all sat there in confused silence, until I broke the spell and bid ten bucks.

Soon afterward, several other students caught on and I was quickly outbid. The bidding went to $40, $50, $75, $85, $90, $95... and finally one guy in our class idiotically bid $99 cash for a $100 check that he might get next year.

I think that guy later went on to work in mortgage-backed securities.

Okay, what's the point? The point is that money paid in the future is worth a lot less than money in your hot little hands today. It should also go without saying that a mere promise to pay you money in the future is worth hella lot less.

All of this explains why the insurance industry--which is in the business of taking money from you today in exchange for a promise to pay you if you experience a loss in the distant future--is hilariously profitable.

And yet insurance seems like such a mathematical, quantitatively-driven product, doesn't it? "I'd like one million dollars in life insurance coverage. How much will it cost?" And the friendly agent checks the book, quotes you a price and helpfully offers you a whole suite of investment products that he can wrap around his policy. All of which are designed to help "protect" you from what is really a highly emotional situation... triggered by the fear of your own death.

An extended warranty is just another form of insurance. The product you buy--whether it's a DVD player, a car or a that brand new blimp you've always wanted--will have some form of warranty already offered by the manufacturers. After all, they want to at least try and convince you that their product isn't defective right out of the gate. So you might get a three-year warranty on your car automatically. But then the dealer wants to sell you extended warranty coverage. He wants to sell you protection that doesn't even begin until year 4. And he wants in exchange a lump sum payment now.

Did you know that extended warranties are among the most profitable products sold at Best Buy? That a good conversion rate for extended warranty sales can have an enormous impact on an auto dealer's profitability?

What does this imply about the value you get as the consumer on the other side of this trade?

If you are ever asked to enter into an exchange of your money today in return for a promise of some amount of money in the future, be very very careful. You are most likely egregiously overpaying.

That's why I only bid $10 for my cute professor's check.

Next up: Rationalization and Justification

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Aleria said...

I got an extended warranty on my first laptop when I bought it. It had no problems for the first year under the manufacturer's warranty, but the next two years under Staples' warranty, I took it in for software fixing, hardware replacement, and general wtf issues. The insurance was only $100 to begin with, and I easily made more than that with all the servicing I had done.

Sarah Walker said...

I have had similar experiences as Aleria, both with laptops and our car. I think there are warranties that are worth it and some that aren't. For most electronics that we would more likely replace than fix, it is obviously not worth it. However, for our new car that we intended to beat into the ground, it was worth it for sure.
Another angle on this discussion is health insurance, right? But that is a HUGE topic. Even pet insurance is something that I will be purchasing for sure with my next puppy. Right now our elderly dog doesn't have enough "blue book value" to substantiate the huge premiums that would come with her pre-existing conditions :)

Daniel said...

Interesting thoughts. I think with PCs, laptops and consumer electronics, I'd personally avoid extended warranties. Generally, these products depreciate so massively in the first few years that by the time the extended warranty kicks in, the product is worth a tiny fraction of its original value.

In my view that's a great business--for the company selling the warranty.

With regard to health insurance, I'm too far out of my area of expertise to voice much of an opinion. Pretty safe to say though that we as human beings don't depreciate quite like consumer electronics.

Thanks for both of your insights.


Nathalie said...

I had similar experiences as Aleria and Sarah with my laptop. A lot of dead pixels appeared in the screen during the 2rd year, they replaced the laptop for a new one because they couldn't change the screen. I think warranties can be worth it if we think about these things, but not worth it if we buy it without thought (and surely very profitable to the industry in that case).

I know that electronics depreciate very quickly, but I'm not sure I understand this as an argument not to buy a warranty. Here is my reasoning: if my laptop breaks and the warranty covers it, good. They fix it or sometimes even replace it with a new (not depreciated) laptop. If I don't have a warranty, I have the choice between paying to fix it, or buying a new one. Since they depreciate so fast, no point in paying for the repairs (that are more expensive than the extended warranty). No-one considers buying a old laptop of equivalent depreciated value to replace the one that broke. (That means buying second hand; you don't really know how well the other person took care of the item and it's possibly a very bad investment.)

Therefore to me a warranty is a tool to extend the life of my purchase and postpone the cost of buying a new one. Of course I drag my purchase out for years (my computer is 7 years old with only 1 or 2 new parts and my laptop 4 years old). People like us who take care of our things and use the heck out of them might be the exception. If, like my computer geek boyfriend, I *need* the top notch technology and will change my computer every 2 years anyways, than the warranty is truly not worth it and the industry would be making a lot of money off of my warranties.

What is your opinion on house insurance (like against fire and water damage)? I've been resisting buying one, but my family thinks I'm nuts not to have any 'protection'. Might be I would be sorry if my home goes up in flames, but it seems like a waste of money to me now.

Daniel said...

Nathalie, this is an excellent question, and I'll confess up front that I'm slightly out of my area of expertise. But that never stopped me before. :)

Here goes. Remember what insurance really is: you make a regular premium payment--that you are guaranteed to lose--in exchange for protection from a risk that may be quite low in probability.

Therefore, if you can protect yourself from a given risk with your own savings, you should--and save the money you'd otherwise pay on an insurance premium. One obvious example is to save an extra $1,000 dollars in your emergency fund, and then raise your auto insurance deductible to $1,000. You've already got the money handy in your own account to cover the added (potential) liability, and you can also save money with the resulting lower insurance premiums. The savings you can get by doing this can be pretty substantial.

Essentially, my view on insurance is you should use it to protect yourself from catastrophic losses, not minor losses... and you should put yourself in a situation to protect yourself from minor losses by having a healthy emergency fund saved up at all times. But, again, that's just my view. I'd love to hear any differing opinions.