Decorative illustration of diminishing returns

Diminishing Returns in Personal Finance

Some people are never able to satisfy their need for more money and will sacrifice everything else as they continuously increase the speed of the hedonic treadmill on which they spend their days. If we are to avoid this trap, it is important to ask ourselves what is enough. But, can we ever really get enough? Of course, we can. But, to get there, we need to liberate ourselves from the shackles of consumption, and the mindset that happiness is a function of how much money you spend.

Learning From Those Who Came Before Us

You don’t have to take my word for it, however. Instead, let us look at what those who already allocated the precious little time we get on this planet, and learn from their professed mistakes. Palliative nurse Bronnie Ware chronicled the most common regrets of dying people and recounted the top five regrets in this article by The Guardian. Do you think not working enough appears on the list?

It doesn’t. In fact, the second most common regret among the dying people Ware encountered, was “I wish I hadn’t worked so hard.” Every single male patient Ware met, that was close to death, had this regret. Here’s what she had to say regarding that particular regret:

This came from every male patient that I nursed. They missed their children’s youth and their partner’s companionship. Women also spoke of this regret, but as most were from an older generation, many of the female patients had not been breadwinners. All of the men I nursed deeply regretted spending so much of their lives on the treadmill of a work existence.

In fact, we can interpret all five most common regrets as people wishing they had been more conscious about what truly impacted their lives in a positive direction, and less time living up to the expectations of a consumer-centric society. I previously shared some thoughts on why more money in exchange for less time is a losing proposition for me. Although the inflexion point may differ from person to person, I believe this is phenomenon holds true for everyone, and that we can use a concept from economic theory to explain it.

The Law of Diminishing Returns

A fundamental concept in economic theory, the law of diminishing returns, relates to production processes and states that at some point the marginal increase in output will go down if we keep adding more of one production factor while maintaining all others constant. In other words, let’s say you produce small trinkets and sell them on Etsy for a living. Put simply, your one and only factor of production are the hours of labour you put in. Starting out, you improve your precision and efficiency as you put in more hours, and you can produce more and more trinkets per hour you work. Your marginal output is increasing.

Poorly drawn chart illustrating decreasing marginal output.
Marginal output, represented on the Y-axis, decreases as you apply more of a single production factor, here labour, represented on the X-axis, while keeping all others constant.

Eventually, you reach your maximum efficiency, and you are not able to improve the effectiveness with which you produce your trinkets any further. Conversely, you instead find that by adding more working hours, you produce fewer gadgets per extra hour worked because you become tired, and make more frequent mistakes. You may want to object and say that you can circumvent the law of diminishing returns by adding another pair of hands to your operation, and scale it up while at the same time avoiding the problems of fatigue. And, sure, you could, but how much space do you have? At some point, the “factory space” in the back of your garage will get cramped, and your subordinates will get in the way of each other, and marginal output will decrease. The law of diminishing returns will impose itself on your operation, sooner or later.

Does The Law of Diminishing Returns Apply to Personal Finances?

It may seem arbitrary to pick a concept from economics and apply it to personal finance. However, there is research indicating what looks like the law of diminishing returns imposing itself in personal finance. Before presenting what constitutes evidence in support, let us investigate the logical argument to see if it even makes sense to ask the question.

Consider our lives an operation, with the objective of producing a particular output. It is not up to me to tell you what your output should be because every person has different goals and objectives. For some, it may be happiness or contentedness, while others target wisdom or enlightenment. One of the very few wrong answers to what your output should be is the one that so many of us spend our lives chasing: Money. Coin only has value as long as it helps us achieve what we pursue. Or, put another way, if our lives are a factory producing an output, money is not the output, but rather a factor of production. One part of the many factors we use to “produce” happiness, wisdom, or whatever it is we pursue.

Starting out with no money, acquiring just a little of it gives tremendous results. We can purchase food and shelter, and if we get enough, we can cover all our base needs. Sorting out our core needs is of course extremely beneficial to our roles as factories trying to produce contentedness because it allows us to focus on the task at hand, rather than worrying about food and shelter. Our marginal output increase with every bit of money we acquire.

As we reach the point where comfortably cover our base needs, we will quickly find that throwing extra money into the production no longer yields incredible marginal increases in output. Yes, buying more stuff is awesome, and going for a swim in your cash pile every morning, Uncle Scrooge-style is pretty awesome. But it rarely adds lasting increases in our production of whatever we have defined as our purpose because money is just a factor of production with limited marginal returns in the long run. And, in most cases, there is a double effect to this, because money often comes at the expense of another of our production factors: Time.

As mentioned, several studies have uncovered results that seem to indicate the law of diminishing returns at play in personal finance. A study from 2010 by Nobel Prize winners Angus Deaton and Daniel Kahneman, as recounted in this Business Insider article, found that “everyday contentment” starts to level off after your income surpasses $75,000 per year. Other studies have found different numbers, while Financial Samurai has made a case for $200,000 being the optimal yearly income for happiness. Regardless of the number, all of these findings point to the fact that the law of diminishing returns is at play in our personal lives as well.

The Implication of Diminishing Returns

Two paragraphs back, I casually mentioned time as another production factor of what producing what it is we want from our life. In fact, I would argue, it is the most important factor of all. Unlike money, time is the one thing of which we only get a finite supply. While nobody can tell you exactly how much you will get, the only certainty of life is that at one point your time is up.

Realising, and internalising, this is important, especially when we consider the relationship between time and money, the perhaps two most important factors of production. One often comes at the expense of the other. With this in mind, consider the inverse implication of The Law of Diminishing Returns. If adding something you already have a lot of will result in decreased marginal output, the value of something you are in short supply of will be that much higher. Said in other words: If your life is a factory producing happiness, and time and money are the two factors of production, earning more money if you are already busy will not result in more happiness.

Illustration of relationship between the marginal utility of time and money
Money and time are inversely correlated, and as you increase the amount of money, the value of each extra dollar declines, while the value of time increases.

I have tried to draw the results of the above realisation in the illustration above. (I’m sure you’re wondering why I didn’t pursue a career as a graphic illustrator at this point. The short and long of it is I find numbers more interesting!) On the horizontal axis, we have money and time at our disposal. The further to the right, the more money, and less time. The vertical axis represents the marginal value of acquiring one more unit of money or time.

As we can see, and agreed upon earlier, as you are strapped for cash, it makes sense to sacrifice time for money. The marginal utility of acquiring more money to cover your base needs is higher than that of having extra time at your disposal. However, before long, the curves intersect, and it becomes clear that past this point, it is more beneficial to your purpose to take control of your own time, rather than focus on accumulating more money. We have seen that research results support this thesis. Unfortunately, as we know, most people fail to change their mindset at this point and continue to prioritise money over time.

Where Do The Curves Intersect, or: What Amount Of Money Is Enough?

Despite the best efforts of media and academics alike, nobody but yourself can answer this question for you in any meaningful way. Some people value resources and money higher relative to time than others, and that is fine. What is important, is to maintain a conscious relation to why you prioritise as you do, and never forget that, while covering your vital needs is pivotal, time is the only truly scarce resource in the production mix of your life.

Person jumping with joy in sunset.
Focus on discovering what truly impacts your life, instead of accumulating stuff.

Define your own purpose, and from there on do your best to balance between prioritising time and money. And don’t forget that by figuring out what really affects your happiness or contentedness (it is not more stuff!), you can increase your savings rates, and put more money to work for you, giving you more freedom to allocate your time as you see fit. If you haven’t already, be sure to read The Basic Principles of Personal Finance to learn more about this.

Header photo by Rabelais.

10 thoughts to “Diminishing Returns in Personal Finance”

  1. Great post Lars-Christian – as always, you look to focus on the “personal” side of personal finance. I love it!

    I think about this concept a lot: how can I maximize my use of time? Right now, I’m spread fairly thin between my blog, some side consulting work, and my day job. It will be interesting in the coming months.

    To be honest, I want to quit my day job given my blog brings me so much more enjoyment. In addition, the sky is the limit with the internet!

    1. Thanks, Erik!

      I definitely agree with the sentiment that the sky is the limit when it comes to the internet. Having previously lived my life as a full time online entrepreneur in my younger years, I have to say that I don’t miss the stress levels of not knowing how large my “pay check” will be each month, and knowing that my visitor numbers each day directly influence how much I have to spend the next month. That’s the stressful life of an entrepreneur though, I suppose! Being in a more stable financial situation, I’d probably handle it better these days. But for now, I’m quite comfortable in my job, and with the predictability it provides 😄

  2. Interesting post, Lars-Christian. And I love the economic mindset you take in evaluating the relationship of time and money.

    Recently I’ve become more and more focused in determining when enough is enough for me. It’s helped to prioritize the important things in life to me and determining their costs, etc. I want to work hard now so I can enjoy more of the fruits of my labor later and hopefully not have the regret on my death bed that I didn’t work so much.

    1. Thanks for stopping by, and leaving a comment Green Swan!

      Just having a conscious relationship to what is enough for you, and why you do what you do, puts you way ahead of the curve. I am definitely in the same boat as you, in that the last thing I want is to regret working more than I had to. I’m also trying to balance the “work today for a better tomorrow” against the fact that today is the only day we’re guaranteed, which is a tough balance to find.

  3. This post highlights the need for measurable and achievable goals. It’s the only way to know when you’re “done” with something you set out to do. Keeping your eye on something that is measurable and achievable can help you avoid that hedonic treadmill.

    Personally, I want to have enough passive income so that I can ensure that my parents and siblings are taken care of. I’d like to be able to spend my life enjoying their company and hanging out with friends, rather than running on a never-ending treadmill. For that I’ve identified what I believe to be a healthy amount of savings and a healthy amount of passive income and try not to overdo it during the journey.

    1. Yeah, that’s absolutely an important point to counter the hedonic treadmill. I would make a case for always reviewing and revising your goals though, and highlight the importance of finding value in the journey as well, which it sounds like you’ve got covered 😊

  4. The concept your describing here is more formalized in Economics as the concept of Marginal utility. That is the value of each additional item of something, happiness or otherwise, has a different value to someone then the last. So in your example the value of money in the approach to fi or support your lifestyle depending on if your looking at retirement or income is within the high marginal utility area. However as you approach the upper ends an extra unit of money is worth less to you personally representing a flattening of the marginal utility curve. Time meanwhile has a similar aspect, but is generally bounded. I.E. if we could all live infinitely the value of a minute would be essentially 0. The value of the minute is proportional to the position on the curve in relation to your expectation of the bounds. So if you expect to live to 60, then your curve will flatten out lower (in theory) then a curve with a bounded end point of 100. The tricky part is everyone has a different perception of when the time bound occurs (when they die) and how long a period of time really lasts. IE. 30 minutes to me is not the same from a perception perspective to me as it is to my 4 year old.

    Sorry if this is deeper then you expected.

  5. Yes! First, huge love for the charts and graphs. (Extra credit for the hand-drawn graphics!) Second, I think you just inadvertently captured part of why the zeal of the big wins early on in personal finance reform cannot be sustained. Once we’ve saved enough to pay off debt and providing certain kinds of peace of mind, there are fewer “returns” twinkling out there in the distance to provide motivation. Finally, you have given me the courage that I can write a post on cost distribution smoothing when it comes to personal budgets and someone will appreciate it! 😉 Thank you for this post.

    1. Thanks Melanie. I had to make do with drawing on my iPhone, as my iPad was occupied by my spouse as I was trying to make the illustrations. Pretty happy with them all in all, that considered 😉

      And that’s a sharp observation on the value of the early, big wins. Plus, I’m very much looking forward to read your post applying cost distribution smoothing to personal budgets, so that’s something you absolutely should do as soon as possible!

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