Law of Diminishing Returns | What Is It? | Investor Junkie

It may seem strange to discuss a topic like diminishing returns on an investment site, after all aren’t we all trying to increase our returns? Yes, but in economics and investments, diminishing returns is a very important topic to understand. You don’t want to continue your same efforts, with the same (or even less) reward for your hard work.

What Are Diminishing Marginal Returns?

So what are diminishing returns exactly?

In street language, this term often means something like too much of anything isn’t good for you, but it’s actually a bit more technical than that.

Investopedia.com defines it under the more precise description of the Law of Diminishing Marginal Returns as follows:

Advertisement

“A law of economics stating that, as the number of new employees increases, the marginal product of an additional employee will at some point be less than the marginal product of the previous employee.”

Under this definition, the basic concept is that a business, say a factory, that employs people to produce a product will at some point find that each employee added will provide a lower level of output than the previously hired employee. We can probably say that the first 50% of employees hired will be more productive than the last 50% hired.

At some point the diminishing returns per employee can become so severe that the business will actually see a decrease in production. This may help explain why so many production oriented businesses are shifting from employees to robotic systems or machines.

Now this definition centers squarely on diminishing returns as it relates to hiring employees, which is likely where the whole concept originated. But diminishing returns can actually be applied almost anything in life that requires increasing quantities of whatever we’re trying to get.

Examples of Diminishing Returns

Diminishing returns really does apply to virtually any area of life, but most especially in your finaces. Let’s look at some examples:

Eating. Each of us needs a certain amount of food in order to live. But beyond a certain point, eating is subject to diminishing returns. Eat too much, and you will begin to gain weight. This will become counterproductive, since it will have the exact opposite effect of maintaining your health, by causing a decline from being overweight.Exercising. We also need a certain amount of physical activity in order to maintain good health. But if you take it too far, not only do the health benefits begin to decrease, but it can begin to negatively affect the rest of your life. All the time spent exercising can take away from other important areas of life, such as career, family and social interaction.Leisure. How could you possibly have too much leisure? But after a while, even leisure gets boring! And leisure is only leisure because it isn’t one of the more mundane activities in your life, like earning a living, or saving for the future. But with too much leisure brings decreased amounts of enjoyment. This is a major reason why people who retire often return to the workforce a few years later. A life of absolute leisure isn’t as satisfying as it seemed during the working years.Working. We can easily see how diminishing returns applies to work just from looking at the tax code. Since the federal (and most state) income tax structures are progressive (tax rates rise with income), the last dollar you earn puts less money in your pocket than the first dollar. But even beyond money, working too much can wear down your health and impair your family and social environments.Investing. Generally speaking, saving money never has an end goal. Once you reach a certain financial milestone, you’ll have to create a new one and continue striving towards that one. And there’s a high chance of becoming too greedy because of this. We can never truly know what the market will do, how much inflation will rise, or if we have enough saved up for our retirement, and because of this, it’s hard to pinpoint an end goal.

Diminishing returns will actually apply to virtually every activity in your life, but these are just some of the more common ones.

Diminishing Returns as it Applies to Investing

So how does diminishing returns affect your ability to invest and save? Let’s dive into how diminishing returns can affect your investments more directly.

Enough is never enough. One of the problems in accumulating money is that once you reach one goal, you’ll usually set another. And another. The chase for greater riches becomes a Catch-22, in which you never actually reach the goal line. You spend your entire life always chasing a bigger pile of money. That’s not a bad thing if you can do it in a kind of passive, automatic pilot sort of way. But if it becomes your primary goal in life, it can get in the way of a lot of other things.

Back-loading your life. Investing is very much about preparing for later, and to a certain degree this is a healthy pursuit. But when you’re giving up everything now for a better tomorrow, you have to accept that you might be sacrificing the best years of your life in the process. For example; by the time you reach your financial destination, your health is no longer with you. Reality makes it clear that not everyone lives long enough to collect the fruits of their labor. You have to balance this into the cost of any long-term endeavor.

Neglecting other areas of your life. While it can sound noble to spend your twenties and thirties saving up for early retirement at age 50, a lot of other things are happening around you. Your marriage is one, and your children growing up is another. Also, your body is getting older. If you aren’t careful to take care of it, you could very well be without good health when your financial ship finally comes in.

Hogs get slaughtered. Ever heard of the term, “pigs get fat, hogs get slaughtered”? Basically it refers to greed being your downfall. Greed is one of the biggest drivers in the investment markets, and also for individual investors. If having the biggest pile of money is the main objective in your life, it’s possible you’ll start chasing investment returns right into very high risk territory. This kind of investing activity sets you up for a big fall at the wrong time.

With investing, as with virtually every other area of life, you need to have a healthy perspective on exactly what it is you’re doing. Investing is just one aspect of your life, and you need to give equal time to all the other areas. And that’s not an easy thing to do if you’re making a lot of money on your investments.