Wealth has a diminishing marginal utility. This, in my view, is the most important argument, the
one I stress with my clients when helping them plan their future. Even if the first two reasons (here and here) didn’t apply, an investment strategy designed to serve real lives mustn’t overlook this one: $2 is not twice as valuable as $1.
People often forget the difference between price and value. The price system in a free market simply provides the information to buyers and sellers as to the exchange rate between different goods and services that will avoid both shortages and surpluses. On the other hand, a voluntary exchange between a seller and buyer is not an exchange of “equal value.” Clearly, the seller wouldn’t provide the good or service unless he preferred the money, and the buyer wouldn’t exchange the money unless she preferred the good or service. Both parties must believe they are receiving something of more value to them than what they are relinquishing, or the exchange wouldn’t take place (with the exception of coerced exchanges in which one of the parties to the exchange is a violent criminal or government official).
Why is this important? Well, since we each have limited resources, we will typically look to exchange them for things we value most highly. We must have valued those things more highly than alternatives we didn’t choose or else we would have chosen the alternatives. So when we get more resources and can now acquire those alternatives, we must be acquiring things of less value to us with those additional funds. This is the diminishing marginal utility of wealth.
There is nothing all that surprising in this observation. The caveman first uses his time to acquire food. With a little more time, he can find food and shelter. With more, he can acquire food, shelter, and clothing. After that, food, shelter, clothing, and car insurance from GEICO. And so forth. Each thing added is less valuable to him, even though it may be more expensive to acquire.
Since money is nothing more than a medium of exchange, its value is in what can be acquired with it. (Even when money is a useful commodity, such as gold, its value as a medium of exchange eventually dwarfs its value as a commodity for most people.) Since the things you acquire with money will be, at least unconsciously, affected by how you rank the value of your options, twice as much money will always be less than twice as valuable to you.
Up to a point, the things you need to acquire are so critical that the diminishing value of wealth isn’t obvious. After basic needs are met, however, most people will acknowledge that much of their spending adds comparatively little to their happiness. Some studies actually suggest that wealth beyond basic needs adds next to nothing to personal happiness, and my own experience with clients is that, once basic financial independence is achieved, their satisfaction with life depends primarily on the quality of their personal relationships and not on their surplus wealth. We can debate the magnitude of the drop-off in value but not its existence. Achieving your financial goal from investing is valuable, exceeding it much less so.
Thus, average-return calculations that depend heavily on the occasional jackpot massively overstate the value of a strategy. Less-diversified strategies always do.
Let me note that there are ways to raise the median result through methods other than diversification and that I don’t necessarily endorse such methods, especially when they increase the probability of a horrible outcome. (For example, going without insurance against catastrophic events increases your wealth most of the time, but reduces it substantially if the catastrophe occurs.) We are ONLY talking about the benefits of diversification in this piece. And in such cases, the median and mode, not the mean, are the most meaningful averages.
OK, I hope I’ve made the case for diversification. Now let’s start on how to build a diversified portfolio.