Another example of a bad deal is life insurance on children. In rare cases where a child actually has a substantial income that others depend on, it can make sense to take out life insurance on the child. But, in most cases, insuring a child’s life makes no sense; remember that the insurance offers no protection from death! I have had insurance agents try to talk me into insuring my children by arguing that I would need to cover funeral expenses, and that buying the insurance would guarantee future insurability. This was all nonsense. I can afford a funeral without the help of insurance, and if I couldn’t, I would choose something less costly than the standard funeral. The future insurability argument requires more explanation. When you buy term life insurance for, say, 10 years, it comes with or without the guaranteed right to renew the insurance at a particular price after the 10 years are up. If your insurance is renewable, then even if you develop a terminal illness in th...

Have you ever been to see a doctor who is obviously upset about something that has nothing to do with you? This has happened to me a couple of times where a doctor was complaining about something and I had little choice but to sympathize even though I was much more concerned about my own problems. Otherwise, why would I be seeing a doctor? One of these times the doctor was having a problem with her extended health coverage for topping up the basic Ontario government medical coverage. Her partners wanted her to go in with them on a plan that cost $400 per month for each doctor, but she saw in the fine print that the plan had a lifetime cap on all benefits of $25,000. She correctly figured out that she would pay $25,000 in premiums in just a little over 5 years. I asked her if she could afford to pay $25,000 right now if she had some sort of medical problem, and she said yes, which isn’t too surprising for someone with the income of a successful doctor. So, this means that the insura...

Some financial decisions, particularly about insurance, must take into account what is called the utility of money to get the right answer. Normally the concept of utility is explained in very mathematical terms, but it doesn’t have to be. Let’s take a fun example straight from a game show. You’re standing beside Howie Mandel playing a super-sized version of Deal or No Deal. You’re down to just two amounts left, 1 cent and $3,000,000! You get the following offer: take $1,000,000 now, or take a 50/50 chance at the $3,000,000. What should you do? If you got to do this many times, then on average, taking the chance you would win half the time and get an average return of $1,500,000. This is more than the million dollars you were offered, and so you should take the chance, right? Not so fast. Most people would correctly figure out that they should just take the million dollars. The reason is that the first million would make a huge difference in their lives, and an additional two mil...

In my last post, I discussed how insurance is a financial matter and doesn’t do anything to prevent accidents. So, if insurance is just about trading money back and forth, how can it be a good deal for both the insurance company and the person buying the insurance? When it comes to buying goods like food, it is easy to see why an apple is more valuable to a person buying one than it is to the farmer who owns an orchard full of apples. I’m quite happy to part with 50 cents for an apple when I’m hungry, and farmers are willing to take less than 50 cents for each of their apples. So, in this case, it is possible for both sides to win. When it comes to insurance, it isn’t as obvious that both sides can benefit. To keep things simple, imagine that a car insurance company has worked out that they will have to pay out an average of $600 per driver in claims for car accidents next year. If they charge each driver $1000 for the insurance, then they will make a $400 profit on each driver min...

A while ago during a temporary gap in my house insurance, some of my friends joked about coming over to my place and “having an accident” to make some big money. Of course they weren’t serious, and we all had a good laugh. Later on I thought about what had made the joke funny. If you think about it, a fraudster would have better luck getting a big settlement from an insurance company than from me. So, for a short while my house was probably the worst place to target for faking an accident. But my friends and I all got the joke instantly, even though it doesn’t seem to make much sense after some thought. What is going on? To answer this you need to look at how house insurance is marketed and sold. The best example is one insurance company that shows the image of a giant protective blanket enveloping your house. As long as you don’t think about it too much, you have the feeling that house insurance actually helps prevent accidents. The marketing promotes this subconscious idea. Of co...

In my last post, I discussed how stock price increases over the long term are possible. A reader, Steve, asks “If the value of stocks keeps on rising at a greater rate than inflation, wouldn't that mean that less and less people could buy stocks in the future due to lack of necessary funds?” This is a good question that points to the seeming paradox of the stock market creating value out of nothing. Let’s start with understanding inflation. Inflation is a measure of the increase in prices of the things we buy, like food, gas, and clothes. At the beginning of the year, a particular basket of items is selected as the typical things that people need, and the price of this basket of items is added up over the course of the year to measure the cost of living. If inflation is 3% one year, then the cost of this basket of items has risen 3%. Another way to view this is that the things we buy have constant value, and the value of money has dropped. Now, just because inflation is 3...

Over the last 100 years, the Dow Jones Industrial Average has gone from about 65 to 13,000, a factor of 200. But this is only about half of the return because it doesn't include dividends. So you can multiply this by another large factor to get the full returns. Of course stocks have had some major blips in the last 100 years, but this represents a relentless rise in stock prices. Even factoring out inflation, stocks have made an impressive long-term run. In the short term stocks rise because there are more buyers than sellers, and when demand outpaces supply, prices must go up. Over the long term it seems like the stock market creates wealth out of nothing. Science teaches us the law of conservation of energy, we often hear that there is no free lunch, and we talk of zero-sum games, but the stock market doesn’t seem to be bound by any such law. Over the long term, almost everybody who stays in the game seems to win. What makes stock prices rise over the long term? The short an...