Whether you like it or not, we all have to make bets. The bets we make may not involve gambling, lotteries or casinos, but they are sure involving money and uncertainty. Do you want an example? When you buy a car or a house and buy an insurance, you are not making anything more than a bet; You are exchanging an amount (the value of the policy) in exchange for a higher payment (premium) based on the possibility of an uncertain event (a car accident or problems with your house). This is a kind of gamblimg, as well as health insurance, life insurance and investments. The question here is: Are they worth it?
Common sense always leads us to respond an yes at first. But is that correct? Let's take a simpler example, such as the extended warranty offered by the store when we buy any king of electronic goods. I am sure enough that it's a big deal for retail chains, but is it for you too? Some people say no because the chance of any problem occurring with products that go beyond the factory warranty is very small. Others say that it is not only a chance of a problem to happen, but the time you save and the headache you avoid when you need to exchange the product is worth paying the extended warranty. Luckily the rule to understand whether it really is worth it or not has already been developed centuries ago.
And how do I do it? Very simple, you just have some basic understanding of probability theory.
Now imagine that you are in front of a new TV that costs U$ 600 and offer you the extended 5 year warranty for only "U$ 49". It may seems a small value regarding the total value of the TV...but regardless the apparently low value, this extended warrant does not worth it. Why? Just follow the formula:
Honest Warranty = - Risk of Not Missing Nothing x Warranty Price + Risk of Loss x TV Price
If the result of this formula is negative or equal to zero, the extended warranty does not worth it. Considering the value of the TV U$ 600, this would be your total expected loss in case of any problem. The extended warranty is only worth it if it is less than the value of the TV multiplied by the chance you having some kind of problem in the next 5 years. A quick search on Google shows that less than 5% of televisions give some trouble in five years. So your chance of having no problems with your new TV is 95% or more. Therefore, our formula is:
Honest warranty= 95% x 49 + 5% x 600
Honest warranty= -16.55
As the result is negative, the warranty does not worth it. The fair price of the extended warranty based on the chance of any problem happening to you would be 5% x U$ 1,200, then U$ 30.
Now, if you apply the same formula with your car or home insurance, is it worth paying?
See you next post!