Extended Warranties

There is always the fear you might have a needed repair if you don't buy the extended warranty every company seems to offer at time of purchase (and many times well after that, via mail offers).  Basically, it gets down to managing risk in your life for your consumer purchases. 

What can you afford? 

Will a $500 repair send you to the payday loan operation for a high interest rate loan?  If so and the item you've purchased couldn't be lived without (like a TV or computer, or something really important like that), then maybe the warranty is the way to go.

But, as you start making the inevitable initial and replacement product purchases over your lifetime, think about how many warranties you can skip and still come out ahead.  In our case, my wife and I could have purchased a warranty on the following items:

* Washer
* Dryer
* Range
* Dishwasher
* TV
* DVR
* Computer
* Printer
* Phones
* Cars

There are more, but those are kind of the basics and it's a round number of ten.  Making a reasonable estimate of how much those ten warranties would have cost us, I'd say around $2,000 (give or take).  That's money we now have available to pay for various repairs along the way. 

And, if we don't have any repairs, then it's money in our pocket for future replacement purchases.

If you do have a problem and it's not covered by warranty, you can always drop a line to the manufacturer saying you really like the product, but expected it to last longer.  Most companies want to retain customers and they will sometimes take care of small items.  Always mention you would like to buy your replacement of whatever it is you having problems with, from them, which indicates you'll be an ongoing customer in the future.

People Who Should Be Fired

The vice president of our local office once lamented to me that we had several employees who were not taking advantage of the 401(k) match provided by our employer.  It was 50% on the first 6% of the salary we contributed.  So, someone contributing $3,000 would receive $1,500 from the company as the "match." He wondered how we could inspire people to make at least the minimum contribution so they would receive this immediate 50% return on their investment. My suggestion to him was, we ought to fire them.  If someone is not smart enough to put even a few dollars in an account where they immediately get a match of 50%, then they may not be smart enough to be working at the company.  That's a little harsh maybe, but anyone who can contribute the money and doesn't might need a refresher course in basic math.

Consumer Protection

While I'm a strong believer in free enterprise, capitalism and democracy, I think we could do a better job in the consumer protection area. We recently received a catalog in the mail and I noticed the payment options showed a credit payoff chart. This is something we didn't see a few years ago. It was an item required by law to help people understand what they are paying in the way of finance charges.

Many years ago finance companies were allowed to calculate the APR (Annual Percentage Rate) using different formulas and the result was, you couldn't tell which of the rates were better. It was possible that an advertised 14% rate was actually less expensive than a 13% rate. But you couldn't tell this because of the way the calculations hid the final amount you would pay. The consumer protection movement helped bring a change about that required all companies to display the actual, final APR for all credit. This put consumers in the position of being able to compare apples to apples, which is the way it should be.

Back to the credit payoff chart in the catalog. A purchase of $3,200 required a monthly payment of $96, for 31 years. The total paid would be $15,903. If you paid an extra $50 a month, you'd pay a total of $5,321 and it would be paid off in 5 years. Having this information displayed puts people in the position of being able to decide if they want to pay $15,903. or $5,320 or just save up and pay cash of $3,200. People are free to choose, but at least they can make an informed decision.

We've Always Done It That Way

In the business world it's bad form to say "We've always done it that way" as an explanation for a process, procedure or method of doing business. In general I agree. But, as an example of how this can somtimes be a good thing, I realized my wife and I don't know any of the terms, conditions or interest rates on any of our credit cards. Normally this is the type of information you need to stay on top of, but the reason we don't is because we always pay our credit cards off in full, every single month, within a few days of the monthly statement being issued. This one single habit saves us money (by not paying interest), time (we don't need to keep track of "payment due" dates) and any grief that might come about from getting behind on debt payments. Why do we do this? Because we've always done it that way!

The One Thing You Don't Want To Do

The one thing you don't want to do is this: Learn about compound interest too late.

Using an exaggerated example, let's say you saved $1,000 a year for 40 years (from age 25 to age 65) and kept it in your safe at home. That would give you $40,000. Then, you discover the miracle of compounding and manage to double your money just at the end of that last year with a compounding rate of 100%. That would give you $80,000.

But, what if you started out knowing about compounding and had that 40 years to make it work for you? If you saved the same $1,000 a year, but compounded it each year at 10% (the rough average of the historical market over long, long periods of time), you would end up with $486,851.

Either way you're saving $1,000 a year. The difference is simply understanding how compound interest works.

Index Funds vs. Hedge Funds

In 2008 Warren Buffett placed a bet, which essentially totaled $1,000,000, against a group of hedge funds chosen by the people betting against Buffett. Hedge funds are the go anywhere, do anything (almost), hotshot investment vehicles for sophisticated investors. His bet was that the Vanguard Index 500 (Admiral shares) would outperform this carefully selected group of five hedge funds over a 10 year period.

One of the big challenges for those hedge funds will be overcoming their expense disadvantage. Annual charges of 2.5% of the account balance are made regardless of performance. On top of that, generally hedge funds take 20% of any gains made. In a good year when your investments might grow $100,000, the hedge fund takes $20,000 of that in addition to the 2.5% annual charge on the total.

Here’s my thought: If Buffett is willing to make that kind of bet, that some of the best and brightest investment minds out there won’t be able to outperform the S&P 500 index, what makes you think you can find investments that will? If you agree, invest in broad market based index funds and go to the golf course or spend your days doing other things which might interest you more.

As of this date (2011) several hedge funds have closed their doors. Since “the bet” did not include releasing the names of the five chosen hedge funds we won’t know if any of the chosen have gone out of business or not. But, that’s another variable to consider in your investment selection and one you don’t have to worry about with good broad-based index funds.

The expense ratio on the Vanguard Index 500 Admiral Shares? It is .07% currently. That means on every $100,000 you pay $70 each year. For a hedge fund you could pay $2,500 each year on the account value at $100,000 (if they allowed you to invest that little). If the Vanguard fund goes up from $100,000 to $200,000, your total expense would be $140 for the year. A hedge fund increasing by the same $100,000 would charge you $20,000 for the investment increase and 2.5% on the account balance, roughly $22,500. Of course, if the hedge fund increases offset the expenses then you’re set. But, assuming non-offsetting underlying performance would you rather pay $22,500 or $140 in expenses for an investment?

Another nice thing about index mutual funds is, they won’t have a “lockup” period. Hedge funds may have a lockup period when you can’t access your money except at certain times (maybe quarterly or annually). Also, hedge funds do sometimes go out of business. For an example, search the Internet for “Amaranth Investors” or "Long Term Capital Management" and check their history.

Update: At the May 2, 2014 Berkshire Hathaway annual meeting, Buffett said the cumulative return of the S and P index fund has been 43.8%, while the hedge funds returned 12.5%.

Numbers

Numbers

Do you trust them? Sometimes you should and sometimes not. We just had new windows installed and in the process of interviewing various companies and checking their proposals I noticed an interesting thing on the energy savings calculations.

One Financial Return projection showed that after 10 years we would have a net cost of basically minus $3,868 (Recovered Costs plus Utility Expense Savings).The windows would actually put $3,868 in our pockets. In other words, they would more than pay for themselves. That seems pretty good, doesn't it?

When I drilled down on the numbers though, I noticed they had used a utility savings of 25% a year and estimated an average annual increase of 8% in energy costs. When I checked our historical records I found our energy costs had been increasing at only a 4% rate for the past decade. So, I went back to them and asked for a revised "estimate" based on lower numbers using what I considered to me more realistic, but still generous, numbers. The cost to us over ten years would be $896. That's a swing of $4,764 in the calculations just by changing a few percentages.

I have no idea what our actual savings will be, but the point is you can play with the numbers quite a bit when you are using "theoretical projections." I asked the person doing the calculations if he had any tangible proof that anyone had experienced actual savings close to the projections he was using and the answer was, "No."

Everything was nicely printed out by a computer and the projection had impressive logos and comparisons to other project returns and all kinds of official looking information, but here's the bottom line: It was a guess.

Being the inquisitive type, I went to a local utility and asked them how to calculate energy savings allowing for the changes in temperature and utility costs from year to year. They called and said they didn't have a handy formula for that. I had received the same energy savings pitch from the furnace company, as the window company, and was amazed there was not a formula of some kind to check the projected results.

We like our new windows but we have no idea how much energy they are really going to save or what "Recovered Costs" we'll actually have, but hopefully a lot. If I ever figure it out, I'll let you know.