With all the commotion going on today, it’s as good a time as any to determine if you’re being guided by the Prudent Man Rule or by some trading algorithm that doesn’t even know if you’re a man or a woman.
Are you guided by someone you can talk with? Are you both on the same page? Your Survival Guy will define the Prudent Man Rule in a minute, but as far as I’m concerned, he’s someone who understands you as well as you know yourself, and maybe even better when it comes to your money.
The Prudent Man Rule
The Prudent Man Rule originated from the Massachusetts Supreme Judicial Court’s decision in the 1830 case of Harvard College v. Amory. The Prudent Man Rule outlined in the court’s statement on the verdict 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 invested.”
In more modern terms, the Cornell Legal Information Institute defines the Prudent Man Rule as “The prudent person rule (also called the prudent investor rule) requires fiduciaries, such as trustees, to invest and manage trust property and assets with the care, skill, and caution that a prudent person would exercise under similar circumstances.”
Times like these are when you realize the truth of the matter: when you thought you were guided by such a philosophy, you wake up in a cold sweat not knowing if that’s true.
Fiduciary vs. Suitability: Know the Difference
Knowing the truth is not second nature because there are plenty of gray areas. Take, for example, terms like suitability standard compared to fiduciary. Do you know which one guides your money? What’s suitable for your advisor to stuff into your portfolio may not be the best decision for you. Know the difference.
An advisor who is a fiduciary is guided by different standards. Not sure which one you’re guided by? Ask. Better yet, get it in writing.
In his 2009 article “The Fiduciary Principle: No Man Can Serve Two Masters,” the founder of The Vanguard Group, John (Jack) Bogle, explained the fiduciary duty as follows:
The concept of fiduciary duty has a long history, going back more or less eight centuries under English common law. Fiduciary duty is essentially a legal relationship of confidence or trust between two or more parties, most commonly a fiduciary or trustee and a principal or beneficiary, who justifiably reposes confidence, good faith, and reliance on his trustee. The fiduciary is expected to act at all times for the sole benefit and interests of the principal, with loyalty to those interests. A fiduciary must not put personal interests before that duty, and, importantly, must not be placed in a situation where his fiduciary duty to clients conflicts with a fiduciary duty to any other entity.
Way back in 1928, New York’s Chief Justice Benjamin N. Cardozo put it well:
Many forms of conduct permissible in a workaday world for those acting at arm’s length are forbidden to those bound by fiduciary ties. A trustee is held to something stricter than the morals of the marketplace … As to this there has developed a tradition that is unbending and inveterate … Not honesty alone, but the punctilio of an honor the most sensitive, is then the standard of behavior … Only thus has the level of conduct for fiduciaries been kept at a level higher than that trodden by the crowd.2
It has been said, I think, accurately, that fiduciary duty is the highest duty known to the law.
Where Is Your Margin of Safety? Find Your Balance on the Efficient Frontier
How about your margin of safety? Are you familiar with the efficient frontier or your risk tolerance? Too often, investors only realize their intolerance to risk after the fact. Risk is often misunderstood and glossed over when times are good, and it’s all you can think about when they’re not.
The Efficient Frontier, created by Harry Markowitz in 1952, measures the efficient diversification of investments that delivers the highest level of return at the lowest possible risk. Investors must consider the trade-offs between risk and reward in their portfolios. You can see on the chart above an efficient frontier line representing risk vs. reward for a portfolio allocated between different proportions of stocks and bonds.
On the vertical axis is the return earned by the portfolios, and along the horizontal axis is a measure of how much risk was taken to earn those returns. As you can see by comparing the portfolio of 80% bonds and 20% stocks to the portfolio of just bonds, as portfolios take on a small number of stocks, the benefit of diversification lowers risk and increases reward. Anything above the line is unachievable because no portfolios earning those returns are available at the corresponding risk levels. And any portfolios that fall below the line can be outperformed with the same amount of risk or have their returns matched with less risk.
Markowitz called diversification “the only free lunch in investing.” Is your portfolio diversified?
Action Line: You want to be guided by what’s best for you. I do too. Are you where you need to be? Let’s talk about it. Email me at ejsmith@yoursurvivalguy.com.
Originally posted on Your Survival Guy.
