The Law of Diminishing Returns

The law of diminishing returns teaches us that there comes a point when assuming additional risk will provide no further benefit.

This is something that every investor should know.  Many otherwise astute investors end up investing their money in risky investments in pursuit of greater returns when the numbers imply that this will most likely not be the result.  If there is anything we learn in life it is that the law of numbers and statistics will usually prevail.  Hence, it is not worth it to chase extra returns when the likelihood is that you will not receive them.

How do you find the point of diminishing returns in your investment portfolio? Ideally you should have a computer or an investment advisor calculate this number for you.  It is a portion of your total investible dollars that will be designated as the maximum amount that should be invested in risky investments.  Whatever that number is it is advisable not to go beyond it.  If you do you are assuming excess and unnecessary risk that is not likely to provide a tangible benefit.

This concept also applies psychologically as well.   For example, let's say you set a goal for yourself to fund the education of your youngest child at State U.  You then invest the money over a course of years and 5 years down the line you find that you are even a bit ahead of where you hoped to be.  However, at that point a friend tells you about a "sure thing" and urges you to put some money into it.  You consider taking some of the money that has accumulated for the college savings goal and using it.

It is at this point that the Law of Diminishing Returns enters into the equation.  The fact is that you have set a goal and you have accomplished that goal.  Should you invest the money and receive a positive return you really have received no additional benefit considering your original goal.  Instead you have incurred excess risk and could have very easily lost the money. 

One of the best places to see the Law of Diminishing Returns in action is at a casino.  The Law tells people they should take their winnings and go home but instead they decide they can do better and keep playing and playing until they eventually lose the entire amount.   Those who can learn to obey this law will do much better both in the casino as well as the stock market.  Though the type of risk and the degree of risk differs greatly in these two arenas the principals are the same.  Thus the Law of Diminishing Returns gives clear-cut answers on how to behave in both environments.  Those who learn this do far better than those who don't.

Information is for educational and informational purposes only and is not be interpreted as financial or legal advice. This does not represent a recommendation to buy, sell, or hold any security. Please consult your financial advisor.