What Is the Prudent Man Rule or Prudent Investor Rule?
Understanding the Prudent Investor Rule and Why It Matters
The "prudent man rule" or "prudent investor rule" are phrases new investors are likely to find when researching how to manage or who to manage their own portfolios. If you've come to this article, like many before you, you're probably asking yourself a series of questions, starting with "What is the prudent man rule?" Why does it matter to you if you are selecting a fiduciary to manage your money on your family's behalf? What makes this phrase, which might make Americans of a certain age conjure up images of old men in mahogany paneled rooms in Boston and New York, so ubiquitous?
Those are great questions. To answer them, we need to back in time to the early half of the 19th century.
The Prudent Investor Rule: How It Began
In the 1830s, a now-famous court case was decided in Massachusetts. Known as Harvard College v. Amory, it involved a man named John McClean, who had passed away seven years earlier on October 23, 1823. His heirs were to inherit what was then a sizable estate, ultimately valued at $228,120. Of that, $100,800 was invested in manufacturing stock, $48,000 was invested in insurance company stock, and $24,700 was invested in bank stock with the remainder consisting of real estate, personal items, and cash.
To his wife, Ann McClean, he bequeathed a variety of chattel, his primary residence, and $35,000 outright. He also left $27,500 worth of financial gifts to others. On top of this, he bequeathed $50,000 to Jonathan and Francis Amory, to be held in trust, with specific instructions that they were to invest or lend the money, "in safe and productive stock, either in the public funds, bank shares, or other stock, according to their best judgment and discretion." The passive income generated by the trust fund was to be paid to his wife, Ann, in either quarterly or semi-annual distributions for her to maintain her standard of living based on whatever was most convenient for the trustees.
When Ann McClean died, the trust fund was to be divided among to charitable beneficiaries. Fifty percent of the trust assets were to go the President and Fellow of Harvard College to establish a professorship of ancient and modern history, covering the salary of the new position. The other fifty percent of the trust assets were to be gifted to the Trustees of the Massachusetts General Hospital for general charitable purposes.
Over the next few years, what followed was a long and complicated series of investments, dividends, distributions paid out as part of an international treaty with Spain, and a host of other legal entanglements that left the trust with less value than it had when was originally established. Then, in 1928, the surviving trustee, Francis Amory, tendered his resignation. Harvard College sued the trustee for the losses, claiming that the money had been invested in risky operating companies solely to provide a high income or the widow Ann while disregarding their interest as a remainder beneficiary.
The court sided with the trustees for multiple reasons. When the decision was appealed, and affirmed, Justice Samuel Putnam famously wrote what is now known as the prudent man rule, or prudent investor rule:
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… Do what you will, the capital is at hazard.
The Prudent Investor Rule: What It Means
To give you a broad, general understanding, the prudent investor rule means that a person given discretionary control over another's assets must only acquire investments or expose the account or holdings to risks that a person of reasonable intelligence would consider wise; that had what was believed to be a low probability of permanent loss all things considered. By way of illustration, someone managing a trust fund or brokerage account under the prudent investor rule would not purchase short-term, out-of-the-money call options unless they were part of a tax or risk reduction strategy as they are inherently speculative.
In subsequent case law and cultural changes in the investment management, the prudent man rule has been taken to require a trustee or fiduciary to behave as he would if he were protecting his own money. This has resulted in guidelines that often include things such as:
- Diversifying assets to reduce correlated risks, including among different asset classes
- Maintaining sufficient liquidity to fund cash flows needs and avoid being forced to sell at an inopportune time, often in the form of safe cash equivalents such as Treasury bills or FDIC insured deposits.
- Judging each security or investment position in the portfolio on its own stand-alone merits and rejecting any that are deemed speculative
- The requirement to remain loyal to the person for whom he or she is managing money, including not taking advantage of them for their own personal gain or on the opposite side of a transaction unless it is fully disclosed and explained
- The duty to regularly monitor investments and the underlying performance of investments for fundamental changes in the nature or risks of the holdings
What happens if a fiduciary breaches the prudent investor rule and you can prove that they purposely took a position that no reasonable person could believe would be safe? You can sue for damages and potentially recover some of your losses by winning a court judgment. The bar is set high so watching your portfolio fall 50% during a time like 2009 isn't going to count. You're looking at someone taking your trust, leveraging it with margin debt, and putting 50% your assets in a single speculative biotech company that is awaiting FDA approval for a new wonder drug.