The Law Of Diminishing Returns And How It Relates To Investing

Summary

• The law of diminishing returns is a well-known phenomenon in economics.
• But it also applies to many other instances in life.
• As it turns out, it also has implications for your investments. And not in the most obvious of ways, either.

If you've ever gone through an economics course, or read some kind of book on economics, you've probably already been exposed to the "law of diminishing returns". This law states (Source: Encyclopaedia Britannica):

… that if one input in the production of a commodity is increased while all other inputs are held fixed, a point will eventually be reached at which additions of the input yield progressively smaller, or diminishing, increases in output.

This is seen over and over in economic activity. There are lots of things where production can be increased by adding more of a given ingredient, but eventually you hit diminishing returns/productivity. For instance, it happens when you add more and more fertilizer in agriculture.

But the interesting thing is that the law does not confine itself to just economics or industrial production. It also works in many other settings. For instance it applies to sports. Training will improve your performance. But at some point, adding more training will just lead to small improvements, no improvements at all, or even regression in your ability.

Another such setting is the acquisition of knowledge in any given field. If you make an effort to learn something, you will get a return from it. But as you get closer and closer to the state of the art in that field, your knowledge will increase ever slower. Were you to reach the state of the art, and you'd have to advance it yourself - which would be an even slower process.

There is another angle

There's also another angle to the law of diminishing returns. As much as you get lower and lower returns for additional effort when you are already proficient, you get much higher returns from your initial efforts.

Recognizing this, you can already see how it can have a substantial impact on your investing prowess. This means that just a bit of effort can already take you a long way. If you put a few hours of effort into knowing more about any given investment, you'll get massive knowledge benefits from it. Indeed, since most of the other individuals will be putting little to no effort, with just a few hours' effort you will quickly surpass 60-70-80-90% of all other investors.

You won't surpass the experts in any given field. But you will surpass every other investor that's not putting in the effort. Then, much like in sports, you just have to choose a setting where instead of competing with the professional athletes, you'll be competing with the couch potatoes.

So how can you acquire investment knowledge quickly?

It's really quite basic. You'll need both general knowledge of how things work - and here Charlie Munger's insight regarding mental models is very useful - and specific knowledge on each investment candidate.

You can get general knowledge both from your education and a keen sense of curiosity about how things in general work. If your education let you down, you can try building it back up just by reading a few hours on each item named on the document I linked to in the previous paragraph.

As for specific knowledge, there are also several interesting sources. For instance, you can :

• Read about the sector your investment candidate is in by following blogs from practitioners in that field. For keeping things structured and for you to archive the blogs as you find them, you can use something along the lines of Feedly;
• Read the most recent SEC filings on the stocks you're considering for investment. I mean above all the latest 10-Qs (quarterly reports) and 10-K (annual report, has more detail):
• Read the transcripts from the most recent earnings calls. You can find these right here in Seeking Alpha. For instance, Tesla's (TSLA) transcripts can be found right here. The other stocks have the exact same section in the exact same spot.
• Read a few perspectives on the investments you're considering. Especially if you can get both bullish and bearish perspectives on them. You can also do so right here in Seeking Alpha. Each stock usually has a few (or many) articles written on it which should cover many important aspects of that stock as an investment. For the smaller stocks, it is advisable to visit Seeking Alpha frequently and include those stocks in your Portfolio - that way you'll know when there are new articles on them and will be able to read them before they go into the PRO archive (which happens 30 days after publication).

If you simply follow the steps above, you're already putting in more effort than 80-90% of all the investors out there. Even if it seems like a simple schedule, you will already be building a significant competitive advantage. After all, the law of diminishing returns also means your first efforts carry large returns.

A Few More Implications

Doing as I said above already gets you ahead of most investors you'll be competing with. But unfortunately there will still be many instances when you're outgunned no matter what the effort.

This is so because there are many people whose entire job is to know more and more about very specific situations. And these people usually work for investors which deploy a lot of money. Going against them is like facing Tiger Woods in his prime on a golf tourney. I don't just mean sell-side analysts here (whose biases might make them less competitive). I also mean buy-side analysts as well as large private investors.

Fortunately, those awesome competitors mostly share a common characteristic. They tend to devote their attention to the largest stocks by market capitalization and liquidity. What this means is that if you want to, you can avoid competing against them. Just like you could avoid competing against Tiger Woods by not entering tourneys he was on.

What does this mean? It means you should do two things:

Invest in smaller and less liquid stocks

First it means that you should try to invest in smaller and less liquid stocks. You should look for stocks with little analyst coverage. There, your efforts will probably mean you'll be outgunning 60-70-80% of the money trying to understand those stocks.

It also helps that smaller stocks tend to outperform larger market capitalizations over time, too. And that less-liquid stocks have the same effect going for them. Those buying more liquid stocks are paying a liquidity premium. If your investments aren't too large, you don't need to pay any such premium.

If you must invest in larger capitalizations, do so through index funds

If you think you need the safety of larger market capitalizations and liquidity, you should remember that these are mostly held by institutions which will have access to dedicated efforts in understanding the products they own. This means you cannot simply surpass them with a small effort.

As such, you need a different strategy. This strategy is to simply invest in larger capitalizations through market-wide index funds. Such will ensure outperformance over 60-80% of the other investors as well. The outperformance won't be extraordinary, but at least it will be there.

Candidates for this type of investment could be funds like the Vanguard 500 Index (VFINX), or common ETFs like the SPDR S&P 500 (SPY) or the PowerShares QQQ Trust (QQQ).

Also, if you take this route, you might want to consider adopting passive investment techniques in general, diversification across asset classes by using other passive investment funds, etc.

Conclusion

The law of diminishing returns also has an alternative interpretation, in that your initial efforts are incredibly productive. This means you can surpass the levels of knowledge of most investors just by trying harder than them and reading a bit more than them.

There are two other implications from this insight:

• One is that your efforts are better compensated in segments of the market where you are competing with couch potatoes who do not deploy the same effort. That would be smaller, less-liquid, stocks;
• And that when you are competing in the big leagues, the way to outperformance is to employ passive investment strategies such as buying low-cost market-wide index funds.

Analyst’s Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.