Prudent man rule

Prudent man rule

The Prudent Man Rule is based on common law stemming from the 1830 Massachusetts court decision - Harvard College v. Armory, 9 Pick. (26 Mass.) 446, 461 (1830). The Prudent Man Rule directs trustees "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". A copy of the Prudent Man Rule is also known as the Restatement of Trusts 2d.

Description

Under the Prudent Man Rule, when the governing trust instrument, state law is silent concerning the types of investments permitted. The fiduciary is required to invest trust assets as a "prudent man" would invest his own property with the following factors in mind: the needs of beneficiaries, the need to preserve the estate (or corpus of the trust) and the amount and regularity of income. The application of these general principles depends on the type of account administered. The Prudent Man Rule continues to be the prevailing statute in a small number of states.

Investment Choices

The Prudent Man Rule requires that each investment be judged on its own merits. Isolated investments in a portfolio may have been imprudent at the time of acquisition. However, as a part of a portfolio designed under a strategy, e.g. a hedge fund, the investment could be prudent. Thus, a fiduciary may not be held liable for a loss in one investment.

Under the Prudent Man Rule, speculative or risky investments must be avoided. Certain types of investments, such as second mortgages or new business ventures, are viewed as intrinsically speculative and therefore prohibited as fiduciary investments. As with any fiduciary relationship, margin accounts and short selling of uncovered securities are also prohibited.

Trend

Since the Prudent Man Rule was last revised in 1959, numerous investment products have been introduced or have come into the mainstream. For example, in 1959, there were 155 mutual funds with nearly $16 billion in assets. By year-end 2000, mutual funds had grown to 10,725, with $6.9 trillion in assets (as reported by CDA/Wiesenberger). In addition, investors have become more sophisticated and are more attuned to investments since the last revision of the Rule. As these two concepts converged, the Prudent Man Rule became less relevant...ADDITIONAL COMMENTARY...This discounting of the relevance of the prudent man rule is more the result of market forces than it is of the needs of individuals for "safety of capital". The 10,000+ mutual funds of 2000 have grown to over 15,000 mutual funds in 2006. Does any advisor claim to be expert on all of these funds? Does any one of the rating agencies promise that the funds they rate highly will perform better than those they don't? The Prudent Man Rule is even more important today than it was in 1830 if for no other reason than that the market has become so complex and no individual advisor or advisory firm can claim to be fully informed about the investments they recommend. Remember, ENRON, WORLDCOM, QWEST?

The modern interpretation of the "Prudent Man Rule" goes beyond the assessment of each asset individually to include the concept of diversification. This is referred to as the “Prudent Investor Rule”. The logic is this: an asset may be too risky to put all your money in (thus failing the Prudent Man Rule) but may still be very diversifying and therefore beneficial in a small proportion of the total portfolio.

References

* [http://www.fdic.gov/regulations/examinations/trustmanual/section_3/fdic_section_3-asset_management.html FDIC Trust Manual]


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