What Is the Prudent Investor Rule?

Prudent Investor Rule Explained

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The prudent investor rule is a law that requires trustees to act responsibly with funds entrusted to them. In other words, the prudent investor rule prevents anyone with a fiduciary responsibility from taking risks with their clients' funds.

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

Definition and Example of the Prudent Investor Rule

The prudent investor rule means that when one person is given control over another's assets, they must make investment decisions that a person of reasonable intelligence, discretion, and prudence could be expected to make. This means choosing investments that do not increase the risk of loss.

  • Alternate names: Prudent person 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 when legal language defaulted to male pronouns and trustees were assumed to be men. Many judicial systems have updated the language to address these antiquated ideas, but some legal text and organizations still use the outdated term.

A mutual fund manager is an excellent example of someone who is required to adhere to the prudent investor rule. When investors buy into the fund, the manager inherits a fiduciary responsibility to make decisions for the fund based on the fund's strategy.

They are also required to ensure that they do their utmost to protect investors' assets and grow the fund's value with educated and reasonable investment choices.

It isn't always possible to keep investments from losing value, but the fund managers must do their best to mitigate losses.

How Does the Prudent Investor Rule Work?

When it was written, the prudent investor rule applied to each investment individually. However, as more people began to understand how diversification helps, the rule was changed to reflect the Modern Portfolio Theory (MPT), which explains why portfolios should be diversified. MPT allows for greater risks on individual investments, as long as the risks are reasonable and balanced by the portfolio. In this theory, risks are managed while keeping the potential for gains.

While the rule was relaxed regarding individual investment risks, there are still limitations. For instance, someone managing a trust fund or brokerage account (guided by 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 as much risk as possible.
  • To maintain enough liquidity (including bonds and FDIC-insured deposits) to fund cash flow needs and avoid being forced to sell when prices have dropped.
  • To judge each security or investment position in the portfolio on its own stand-alone merits and reject any that are too risky.
  • To remain loyal to the person for whom they are managing money by fully disclosing any decisions.
  • To regularly monitor investments for fundamental changes in the nature or risks of the holdings.

Legal Ramifications

If your trustee breaches the prudent investor rule, you may be able to sue for damages. You'll need to prove that they took an unreasonably risky position on purpose. This could allow you to recover some of your losses by winning in court. Portfolio losses alone won't help you win, especially during recessions (when many people lose money).

To win a case, you've got to prove not just that your investment did poorly but that the trustee was the cause for its poor performance. For instance, you may have a strong case if they used margin debt or put 50% of your assets in a single biotech stock that was awaiting FDA approval for a new wonder drug.

State laws dictate how these cases are handled. You should consult a lawyer if you feel like your trustee has breached this rule.

The History of the Prudent Investor Rule

Though the concept has been updated, the prudent investor rule's origins date to the early 1800s and a wealthy man named John McLean. When he died, he left money in a trust 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 to invest, 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 trustees 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 takes the balance of the overall portfolio into account rather than the individual investments.
  • Trustees who don't follow the prudent investor rule may be held legally liable for losses, but it depends on the situation.