There’s an easy way to tell if someone understands the fundamentals of investing—ask them if extended warranties are a good idea.
If they give you the wrong answer, you should probably disregard any investment advice they offer you. If they know the right answer—and more importantly, why it’s the right answer—they may be worth listening to.
So, what is the correct answer on extended warranties? Well, let me tell you about the first time I bought one…
It was decades ago. I was young, barely out of college. I’d moved out of home not long before, and while my rented accommodation already had a TV, I wanted one of my own. Something newer and bigger. Something that was mine.
So, I drove to the nearest big-box store, and stood wide-eyed in front of the massive wall of sample screens. After much hemming and hawing, I settled on a model. Then the clerk, an apparent grizzled veteran of the TV sales game, popped the rhetorical question: “And of course you’ll be getting the extended warranty?”
Seeing my youth and indecision, he laid on the hard sell—“TVs like this are known to fail…the standard warranty is only a year…if it breaks 13 months from now, there’s nothing we can do to help you…”
Looking at the wall of shiny, polished sample TVs, I imagined the despair I’d feel if mine died 13 months later. So, I caved and bought the extended warranty…which of course was a mistake. And not just because the TV didn’t break down 13 months or even 33 months later.
Extended warranties are a complete waste of money. Never buy them. They’re a way of manipulating our base instincts for profit. A clever contraption to feed off something called our loss aversion.
The term “loss aversion” was coined by groundbreaking behavioral economics researchers Daniel Kahneman and Amos Tversky in 1979. The basic idea is that we—meaning all of us—dislikes losses more than we enjoy gains.
So, for instance, if someone gifts you a $100 bottle of wine, you’ll probably gain a fair amount of happiness. But if you bought the same $100 bottle of wine with your own money and then proceeded to drop it on your tiled kitchen floor, you’d feel significantly more unhappiness than you did happiness for getting the free gift.
Or consider this example: you are given the choice between a coin toss that pays off $1,000 for heads and $0 for tails, or being handed $480 in cash. What would you do? In this situation, most of us will take the $480.
Now, say you are given a choice between a coin toss that will cost you $1,000 for heads and $0 for tails, or having to hand over $520. Now, what will you do? In this case, most of us will take the gamble. The point being people are not willing to gamble to give up guaranteed gains, but are willing to gamble to escape guaranteed losses because they feel the loss more acutely.
Retailers tap into these emotions by selling us extended warranties. They know that buying a laptop or TV for $500 feels very different than paying $500 to get a laptop or TV fixed. Paying for repairs feels like a loss.
But here’s the thing: Imagine you get an extended warranty for every single appliance you buy over the course of your life—every TV, dishwasher, air conditioner, heater, refrigerator, laptop, oven, washer, dryer, vacuum cleaner, everything. How much would it cost you? Probably thousands of dollars.
Now, how many of these warranties would you actually end up using? I mean, how many have you used in your life thus far?
Sure, a couple of appliances you buy could break down during an extended warranty period. But honestly, it’s unlikely. Even if they do, the smart financial strategy is to simply pay to get them repaired, rather than buying additional insurance for every single device you purchase.
What’s all this got to do with investing? Well, the same principle applies…
Because we feel losses more than gains, we tend to hold on to investments too long when they’re sliding. Locking in a loss seems like admitting defeat. It feels painful.
Similarly, loss aversion makes people sell rising assets too early, because they have an outsized fear of losing the gains they’ve already made.
Indeed, I have a friend who bought into Axon Enterprises years ago when it was known as Taser, the maker of Taser guns that police departments use. His initial price was well below a dollar per share. When the price doubled quickly, he jumped out, too scared to accept the possibility that it might retreat.
Axon went on to soar.
Within a year, he would have made $400,000 instead of the few thousand that he pocketed. Had he held on until today, he’d be a multimillionaire.
Good investors are prepared for these emotions and take steps to counteract them, such as by putting stops on their investments. With a stop, you can set a fixed price at which to sell your shares in a particular investment, say if it ever drops 10% or 20% from your entry price. This removes emotion from the equation.
Even better is a trailing stop, which sets your automatic selling price at a certain percentage below the share’s high point after you buy in. So, say you buy in at $100 a share, and set a trailing stop at 20%. The initial stop would be at $80. Then imagine the share price climbs to a new high of $150. Now your stop would be 20% below this price: $120. So, you’ve locked in gains while removing loss aversion from the decision-making process.
More important, you allow your winners to keep on running without exiting so quickly that you miss the gains that can literally change your financial life.
Investing is a game of averages. You’re not going to make a gain on every share or crypto or commodity or currency you buy. No one does. Being emotionally prepared for this is part of being a successful investor.
The lesson is to be dispassionate with your investments. Think about your stops before making each investment. They will vary wildly between shares and highly volatile assets like cryptos.
Oh, and never buy extended warranties…