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"No other protection is wanting, provided you are
under the guidance of prudence."
—— Juvenal (60-140).
Altruist follows the Prudent Investor Rule. The Prudent Investor Rule is a legal
doctrine which provides guidance to investment managers regarding the standards
for managing an investment portfolio in a legally satisfactory manner.
Basically, prudent investing amounts to a process which one follows.
If the process followed in making investment decisions is prudent (based on what
is known and not known at that time), then the decisions being made are prudent,
regardless of subsequent results. Example: It would be
imprudent to "invest" one's money in a lottery. The relative prudence of
the decision isn't affected by the fact that the investor may have subsequently
won the lottery. If she won the lottery, then she got lucky and had a
spectacularly good result despite a spectacularly imprudent "investing"
decision. But winning the lottery doesn't justify the imprudence of
playing the lottery in the first place. Indeed, while we'd all like to win
the lottery, it simply isn't prudent to try to do so.
Investing prudently is a process, not a performance
guarantee.
In 1994, the National
Conference of Commissioners on Uniform State Laws developed
The Uniform
Prudent Investor Act, based on the Prudent Investor Rule. The Uniform
Prudent Investor Act has been passed as law, with various modifications, in most states
(e.g., the
Michigan Prudent Investor Rule).
A related model statute,
The Uniform
Principal and Income Act, was developed by NCCUSL in 2000.
Here are some comments thereon. Another related model statute, the
Uniform
Prudent Management of Institutional Funds Act, was developed by NCCUSL in
2006.
Here are some comments thereon.
The Prudent Investor Rule traces its history back to an earlier doctrine
known as the Prudent Man Rule. That legal standard was established in 1830
by a Massachusetts Court decision (Harvard College
v. Amory, 9 Pick. (26 Mass.) 446, 461 (1830)):
"All that is required of a trustee to invest
is, that he shall conduct himself faithfully and exercise 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."
The most authoritative useful description of the
current Prudent Investor Rule is
probably that of the influential American Law
Institute
(in Restatement of the Law Third, Trusts: Prudent Investor Rule,
1992):
§ 227. General Standard of Prudent
Investment
The
trustee is under a duty to the beneficiaries to invest and manage the funds of
the trust as a prudent investor would, in light of the purposes, terms,
distribution requirements, and other circumstances of the trust.
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This standard requires the exercise of reasonable care, skill, and
caution, and is to be applied to investments not in isolation but in the
context of the trust portfolio and as a part of an overall investment
strategy, which should incorporate risk and return objectives reasonably
suitable to the trust.
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In making and implementing investment decisions, the trustee has a duty
to diversity the investments of the trust unless, under the circumstances,
it is prudent not to do so.
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In addition, the trustee must:
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conform to fundamental fiduciary duties of loyalty (§ 170) and
impartiality (§ 183);
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act with prudence in deciding whether and how to delegate authority and
in the selection and supervision of agents (§ 171); and
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incur only costs that are reasonable in amount and appropriate to the
investment responsibilities of the trusteeship (§ 188).
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The trustee's duties under this Section are subject to the rule of §
228, dealing primarily with contrary investment provisions of a trust or
statute.
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The new rule contains five basic principles (the
bold phrases below are taken from Restatement of the Law Third, Trusts: Prudent Investor Rule,
1992):
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Sound
diversification is fundamental to risk management and is therefore ordinarily
required of trustees.
Diversification is a basic tenet of risk management, without
which investment portfolios would tend to be more volatile than necessary while
having similar long-term expected returns.
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Risk
and return are so directly related that trustees have a duty to analyze and make
conscious decisions concerning the levels of risk appropriate to the purposes,
distribution requirements, and other circumstances of the trusts they administer.
The point here is that risk is not inherently bad
though it is prudent to avoid uncompensated, or unsystematic risk when possible
(i.e., through diversification). Investment risk should be deliberately
taken on only when it is judged likely to contribute to desirable investment
performance for the portfolio as a whole. The level and nature of
investment risk should be consistent with the trust's need, desire, and ability
to tolerate that risk.
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Trustees have a duty to avoid fees, transaction costs and other expenses that
are not justified by needs and realistic objectives of the trust's investment
program. It is usually both
reasonable and appropriate to minimize incurred fees whenever possible,
consistent with the investment strategy being implemented.
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The
fiduciary duty of impartiality requires a balancing of the elements of return
between production of income and the protection of purchasing power.
This confirms that a strategy which endeavors to generate current income while
preserving principal is likely to result in a reduction of real income to
beneficiaries due to inflation. For that reason (as well as tax-effects),
it is often prudent to invest both for income (i.e., through dividends) and for
capital appreciation, even if it means income alone is inadequate to meet a
beneficiary's cash-flow needs.
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| Trustees may have a duty as well as having
the authority to delegate as prudent investors would.
This delegation is often in the form of
investing in mutual funds. Trustees should exercise due care in
selecting mutual funds for investment, concentrating on the most relevant
predictors of future performance: fees, diversification, and asset class
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For more information, see the articles
below:
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Robert J.
Aalberts and Percy S. Poon, "The New Prudent Investor Rule and the Modern
Portfolio Theory: A New Direction for Fiduciaries," American Business Law
Journal, Fall 1996, pp. 39-71. A good discussion of the Prudent
Investor Rule.
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Frederic J.
Bendremer, "Modern Portfolio Theory and International Investments under the
Uniform Prudent Investor Act," Real Property, Probate and Trust Journal,
Winter 2001, pp. 791-809. "Inclusion of international investments within
a fiduciary portfolio is appropriate and may indeed be required under the UPIA
[Uniform Prudent Investor Act] and MPT."
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Edward C. Halbach, Jr., "Trust
Investment Law in the Third Restatement," Real Property, Probate and Trust
Journal, Fall 1992. A good discussion of the background behind
many of the trust issues covered in the Third Restatement (including the Prudent
Investor Rule). Written by the recorder of the proceedings.
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Eugene F. Maloney, "The
Investment Process Required by the Uniform Prudent Investment Act,"
Journal of Financial Planning, November 1999.
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In
SEC v. Capital Gains Research Bureau, Inc., the US Supreme Court ruled
that section 206 of the Investment Advisers Act of 1940 imposed a
fiduciary duty
on investment advisors.
For more guidance on what this means,
see here.
For a detailed discussion of
surrounding issues, see the Foundation for Fiduciary Studies' Draft of
Prudent Investment Practices: A Handbook for Investment Fiduciaries.
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