So, ya know that feeling when you’ve had just the right amount of your favorite dessert? That first bite is pure heaven, the second is delightful, but by the fourth or fifth… well, it’s just not hitting the same way anymore. Btw, this just happened to me when I ate this gigantic piece of bread pudding. Anyway, that’s exactly how we can understand the law of diminishing returns. Let’s look at how this interesting concept plays out in our financial lives, and how we approach can money management.
Understanding the Law of Diminishing Returns: More Isn’t Always Better
The law of diminishing returns is one of those economic principles that sounds kinda complicated but it actually shows up everywhere in our daily lives. In its simplest form, the law of diminishing returns states that after a certain point, adding more of something produces smaller and smaller benefits. For example, let’s think about watering a plant. The first bit of water brings it back to life, but keep pouring, and you’ll eventually drown it. More isn’t always better.
This concept first clicked for me several years ago when I was obsessively checking my investment accounts multiple times a day. I was new to personal finance and learning about investing. It was like I had this thinking that more attention meant better returns. Spoiler alert: it didn’t. Haha. In fact, it was causing me more stress and anxiety than benefit. Eventually the more you look or check it isn’t providing any grater returns or improvement. Now in the beginning, of course it helps to understand how the market performs, get familiar with any volatility. But eventually, you’ll encounter a law of diminishing returns. More isn’t always better.
How Diminishing Returns Shows Up in Your Money Life
The Savings Paradox
Let me share something that might sound counterintuitive: there’s such a thing as saving too much. I learned this the hard way when I was saving every spare penny into my emergency fund. The first $1,000 was super important. This helped me sleep better at night. Then adding enough for around 4-6 months of living expenses added another layer of security. But by the time I was able to save enough for 9-12 months in my emergency fund, any more saved wasn’t really providing the same peace of mind anymore.
The diminishing returns principle here taught me that while having an emergency fund is essential, however, there’s a point where those additional funds could be better invested elsewhere or in other accounts.
The Investment Time Trap
Similar to when I was continually checking my accounts and investment dashboard, There was time spent researching investments. When I first started investing, every hour I spent learning about index fund investing and market behavior and strategies led to significantly better decisions. But eventually, I kinda hit a wall. The 20th hour of researching the same thing really wasn’t yielding nearly the same insights as the first few hours had. I’m not saying we shouldn’t continue learning and we should remain curious. But that’s when we can shift our strategy or focus on what we are doing to begin to increase our returns again.
The Lifestyle Creep Connection
Perhaps the most fascinating application I’ve found is in spending habits. It kinda reminds me of the hedonic treadmill. Remember that new car smell? It’s incredible for the first few weeks, but soon it becomes just… your car. This is diminishing returns at work in our purchasing decisions, and it’s a powerful reminder that sometimes, enough really is enough.
Let’s say we are buying a new car. You can spend around $20,000 on a dependable new car that gets you key features. This car is reliable, get’s good gas milage, and has all the safety features. Now if we jump to a $40,000 car, it might get you some added comforts like leather seats, maybe a more powerful engine or advanced infotainment system. But once you move into the $70,000 range you’re largely paying for status and brand. Sure, you may get some luxury extras that really don’t really add practical benefits. After a certain price threshold, upgrading offers less and less of a practical advantage, even though the price tag increases dramatically.
Choosing or upgrading your phone is a good example. Let’s say you have an iPhone SE. it’s time to get an upgrade. You look at the iPhone 14, and this jump brings notable improvements. You’d get a larger, higher-quality display, significantly upgraded camera, faster processor, longer battery life. These differences can totally enhance your experience. So by getting the leap in performance, all the features, and overall enjoyment makes the extra cost feel totally worth it. However once you already have an iPhone 14 and are looking to maybe upgrade to the iPhone 16, the additional money spent would offer a somewhat smaller return on value. Sure the iPhone 16 would include incremental upgrades, the jump from 14 to 16 is likely to be less dramatic than going from an SE to a 14.
In the end, sometimes despite products or services having a higher price tag, the differences may not be enough to make the extra cost worth it.
Now, let’s look at some practical strategies to overcome diminishing returns, and feel like we aren’t wasting time, and money.
1. Find Your Sweet Spot in Savings
Instead of blindly maximizing savings, I’ve learned to identify the optimal balance and calculate basic living expenses for about 6 months. Then add about 20% buffer for any unexpected costs. Next, anything beyond this goes into investments and other growth opportunities
2. Optimize Your Time Investment
I’ve started to use what I call the “80/20 rule for financial attention.” I spend around 80% of your financial management time on big-picture, strategic planning. The big moves. Then use just 20% of attention for the day-to-day monitoring and adjustments. After that, attempt to automate everything else possible
3. Create Value Ladders for Spending
I’ve discovered and started using an effective strategy when spending called a “value ladder” for major purchases. Before buying something, I ask myself: Will this provide me, my family, or for whom I’m buying this for lasting value? Could this time, money or effort I’m spending create more value somewhere else? Lastly, does purchasing this product or service align with my long-term goals?
Leveraging Diminishing Returns to Your Advantage
This is where the real magic happens and gets more extreme! It’s when we start using this law of diminishing returns principle as a decision-making tool. Here’s how we can structured a financial approach:
Using Diversification as a Response: Instead of pushing against the diminishing returns, we can learn to diversify when we hit that plateau. When savings start yielding less satisfaction, let’s shift focus to investing. When one investment strategy shows diminishing returns, I explore other complementary approaches that aligns with our goals.
The Compound Effect Strategy: One of the best ways to combat diminishing returns is to stack different types of returns. While my emergency fund might have hit its optimal point, combining it with Investment returns, Skill development, and Side hustle income can creates a multiplier effect that helps overcome those individual plateaus.
Understanding the law of diminishing returns doesn’t mean we should settle for less. Heck no! it means we can be smarter about where we put our time, money, effort, or other resources. It’s about finding that sweet spot, or balance where our effort meets optimal returns across all areas of our life.
Remember, when focusing on the personal finance area of life is exactly that – personal. Your point of diminishing returns might be different from mine, and that’s perfectly fine. The key is recognizing when you’ve hit that point and having the wisdom to adjust your strategy accordingly. By understanding the true power of diminishing returns, it gives you permission to keep those horns held high and be strategic. You can go in another direction rather than just working harder with minimal returns.
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