Prudent Investor Rule

Altruist Financial Advisors LLC
Fee-Only Investment Management

"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. An example of this law, with modifications, is the Michigan Prudent Investor Rule. Here are some comments thereon.

A related model statute, The Uniform Principal and Income Act, was developed by NCCUSL in 2000. Here are some comments thereon. An example of this law, with modifications, is the Michigan Uniform Principal and Income Act. Here are some comments thereon. This law provides guidance on classifying assets in a trust as either principle or income, for the purposes of distribution.

Another related model statute, the Uniform Prudent Management of Institutional Funds Act, was developed by NCCUSL in 2006. Here and here are some comments thereon. An example of this law, with modifications, is the Michigan Uniform Prudent Management of Institutional Funds Act. Here are some comments thereon. This law provides guidance on the management of charitable endowments.

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.

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. 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. In addition, the trustee must:
	conform to fundamental fiduciary duties of loyalty (§ 170) and impartiality (§ 183); act with prudence in deciding whether and how to delegate authority and in the selection and supervision of agents (§ 171); and incur only costs that are reasonable in amount and appropriate to the investment responsibilities of the trusteeship (§ 188).
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.

The new rule contains five basic principles (the bold phrases below are taken from Restatement of the Law Third, Trusts: Prudent Investor Rule, 1992):

	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.
	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.
	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.
	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.
	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 focus.

For more information, see the articles below:

	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.
	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."
	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.
	Eugene F. Maloney, "The Investment Process Required by the Uniform Prudent Investment Act," Journal of Financial Planning, November 1999.

Fiduciary Duty

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.

This web page contains the current opinions of Eric E. Haas at the time it is written—and such opinions are subject to change without notice. This web page is intended to serve two purposes:

	To educate the public; and
	To provide disclosure of Mr. Haas' opinions to prospective clients. We believe that prospective clients are well-served by being made aware of what they are buying—and what they are buying is advice that is based on these opinions.

We believe the information provided here to be useful and accurate at the time it is written. Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed.

No investor should invest solely on the basis of information listed here. Before investing, it is important to consult each prospective investment's prospectus and consider both its risk/return characteristics and its effect on your overall portfolio.

This information is not intended to be a substitute for specific individualized tax, legal, or investment planning advice. Where specific advice is necessary or appropriate, Altruist recommends consultation with a qualified tax adviser, CPA, financial planner, or investment adviser. If you would like to discuss the rationale or support for any particular idea expressed on this web page, feel free to contact us.

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