What Is the Prudent Investor Rule?

Definition & Examples of the Prudent Investor Rule

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The prudent investor rule is a law that requires fiduciaries to act responsibly with funds entrusted to them. In other words, the prudent investor rule prevents financial advisors from acting too recklessly with their clients' funds. Modern Portfolio Theory guides the prudent investor rule.

Keep reading to get a better sense of how the prudent investor rule affects your investments.

What Is the Prudent Investor Rule?

The prudent investor rule essentially means that, when a person is given discretionary control over another person's assets, they must make investments that a person of reasonable intelligence, discretion, and prudence could be expected to make. This means choosing investments that give the overall portfolio a low risk of permanent loss.

  • Alternate names: Prudent person rule, prudent man rule

It's fairly common to hear the prudent investor rule referred to as the "prudent man rule." The court judgment that created this concept was written at a time when legal language defaulted to male pronouns and trustees were assumed to be men. Many organizations have updated the language to address these antiquated ideas, but the legal text and some organizations still call it the "prudent man rule."

How Does the Prudent Investor Rule Work?

When it was originally written, the prudent investor rule applied to each investment individually. However, as more people began to understand the benefits of diversification, the rule was amended to reflect Modern Portfolio Theory (MPT). MPT allows for greater risks on individual investments, as long as the risks are reasonable in the context of the overall portfolio. Therefore, risks are managed without sacrificing too much potential for gains.

While the rule was relaxed regarding individual investment risks, there are still limitations. For example, someone managing a trust fund or brokerage account under the prudent investor rule would not purchase short-term, out-of-the-money options, penny stocks, or junk bonds.

In general, you can expect a trustee following the prudent investor rule to:

  • Diversify assets to reduce risks
  • Maintain sufficient liquidity (including bonds and FDIC-insured deposits) to fund cash flow needs and avoid being forced to sell at an inopportune time
  • Judge each security or investment position in the portfolio on its own stand-alone merits and reject any that are deemed unreasonably risky
  • Remain loyal to the person for whom they are managing money by fully disclosing any decisions
  • Regularly monitor investments for fundamental changes in the nature or risks of the holdings

Legal Ramifications

If a fiduciary breaches the prudent investor rule, and you can prove that they purposely took an unreasonably risky position, you may be able to sue for damages. This potentially allows you to recover some of your losses by winning a court judgment. The bar is set high, so portfolio losses alone won't help you win, especially during recessions (when most people are experiencing losses).

To win a case, you've got to prove not just that your investment did poorly, but that your fiduciary should have known that it would perform poorly. For example, you may have a strong case if your fiduciary used margin debt or put 50% of your assets in a single speculative biotech stock awaiting FDA approval for a new wonder drug.

Legal applications of the prudent investor rule will also depend on state law. Consult a legal professional if you feel like your fiduciary has breached this rule.

The History of the Prudent Investor Rule

Though the concept has been updated more recently, the prudent investor rule's origins date back to the early 1800s and a wealthy man named John McLean. When he died, he left money in a trust that was meant to provide his wife with passive income. Upon her death, McLean instructed that the remaining funds were to be divided between two charitable beneficiaries, Harvard College and Massachusetts General Hospital.

However, when Harvard and Massachusetts General Hospital finally received the donations, it was far less than they expected. They sued the trustee, pointing to evidence that the trust lost value because of investment choices.

The case made it to the Massachusetts Supreme Court, where, in 1830, Justice Samuel Putnam's opinion included the now-famous passage, "All that can be required of a trustee is, that he shall conduct himself faithfully and exercise a sound discretion. He is to observe how men of prudence, discretion, and intelligence manage their own affairs, not in regard to speculation, but in regard to the permanent disposition of their funds, considering the probable income as well as the probable safety of the capital to be invested."

Key Takeaways

  • The prudent investor rule states that fiduciaries must only invest clients' funds in ways that could reasonably be expected to perform well.
  • While it once applied to each investment individually, the prudent investor rule in the 21st century is largely guided by Modern Portfolio Theory, which assesses overall portfolios rather than the individual investments.
  • Fiduciaries who don't follow the prudent investor rule may be held legally liable for losses, but it depends on the specifics of the situation.

Article Sources

  1. Legal Information Institute. "Modern Portfolio Theory." Accessed Aug. 23, 2020.