Diminishing marginal utility of wealth

An extra Rs 1,00,000 means a great deal to someone with almost nothing. The same Rs 1,00,000 barely changes the life of someone who already has Rs 10 crore. The money is identical; what it is worth to the person is not.

This is diminishing marginal utility of wealth: as wealth grows, each additional rupee adds a little less satisfaction, or "utility," than the rupee before it. Utility curves, plotted against wealth, demonstrate this — they keep rising, but at a slowing pace.

Modern Portfolio Theory rests this idea underneath everything else it builds. It is the reason a typical investor is risk averse rather than indifferent to risk: the pain of losing a rupee is felt more sharply than the pleasure of gaining one, once existing wealth is taken into account.

The workbook states this as one of the core assumptions of Modern Portfolio Theory: utility curves demonstrate diminishing marginal utility of wealth, and though investors differ in exactly how fast their marginal utility falls, the underlying principle holds for all of them — per-rupee increments to utility decrease as wealth increases.

This assumption is what makes an investor risk averse rather than risk neutral or risk seeking. A risk-averse investor demands a positive risk premium before accepting risk, because a potential loss hurts more, in utility terms, than an equal potential gain helps — a direct consequence of the utility curve flattening as wealth rises.

Illustrative, since the workbook gives the principle without a worked utility score. Suppose an investor assigns a utility score of 80 to a wealth level of Rs 10 lakh. Moving to Rs 20 lakh — an extra Rs 10 lakh — might raise the score to 95, a gain of 15 points. Moving from Rs 20 lakh to Rs 30 lakh, another Rs 10 lakh, might raise it only to 105, a gain of just 10 points.

The rupee amount added is identical each time — Rs 10 lakh. The utility gained keeps shrinking. That shrinking gap is diminishing marginal utility, and it is exactly why this investor would think twice before risking an existing Rs 30 lakh for an uncertain shot at a further Rs 10 lakh.

Chapter 14 (Introduction to Modern Portfolio Theory), section 14.2 (Assumptions of the theory), lists diminishing marginal utility of wealth as one of MPT's core assumptions, immediately before the chapter defines risk-averse, risk-seeking and risk-neutral investors. Expect a conceptual question linking this assumption to why investors demand a risk premium.

• Diminishing marginal utility does not mean utility falls as wealth rises — utility still increases with wealth, just by a smaller amount each time. Total utility keeps going up; only the rate of increase slows.
• This assumption underpins risk aversion, not risk-seeking or risk-neutral behaviour — those investor types are defined by how they deviate from this default assumption, covered separately under Certainty Equivalent Rate.