It's important for advisors to understand the foundations of prudent investing and other principles that guide investment fiduciaries, and how they are designed to lead to long-term success.

In 1992, the American Law Institute created the Uniform Prudent Investor Act in an effort to apply modern portfolio theory to fiduciary investment practices. The act was viewed as a model that states could enact to provide a new "safe harbor" process for fiduciaries, thus enabling fiduciaries to employ diversification and risk management. It has been adopted as law in most states.

The Prudent Investor Rule, which is part of the act, contains five basic principles:
Sound diversification is fundamental to risk management and is therefore ordinarily required of trustees.
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.
Risk and return are so directly related that trustees have a duty to analyze and make conscious decisions concerning the appropriate levels of risk, distribution requirements, and other circumstances of the trusts they administer.
The fiduciary duty of impartiality requires a balancing of the elements of return between production of income and the protection of purchasing power.
Trustees may have a duty as well as having the authority to delegate as prudent investors would.

The Prudent Investor Rule is a legal standard used by investment managers to manage investment portfolios in a legally satisfactory manner. In the context of the rule, prudent investing is a process that an investment advisor uses to manage client funds.  If the process followed in making investment decisions is prudent based on accepted investment theory, then the decisions being made are prudent irrespective of their outcomes.  

For example, it would be imprudent to have clients invest in only large-cap U.S. stocks. Even if this strategy worked, the client should own a combination of large-cap, mid-cap and small-cap and international equities.  The prudence of the decision is not affected by the fact that a large-cap strategy may outperform a diversified portfolio in a given year. Such an outcome would be viewed as luck, and the use of only large caps would still be considered an imprudent action by the investment manager. Decisions not based on sound financial theory will always be deemed "imprudent."  The most important thing to understand is that prudent investing is a standard for the design of the investment process and not a guarantee of future performance.

Why Invest According To The Rule?
Investing in this manner gives you a structured process for considering all of the relevant factors that should be part of the investment decision-making process.  If you follow the basic principles outlined in this article, you will be well on your way to developing a sound long-term investment strategy.

Advisors who are investment fiduciaries will be held to a higher standard and are legally required to use a process that provides clients with fundamentally sound advice.  Many clients end up getting into trouble when they take advice from a commission salesperson or broker.  It is important to remember that the SEC views a broker as a commission salesperson and not a fiduciary advisor subject to the Prudent Person Rule.

The following is a review of a fiduciary's duties and how they benefit clients.

Duty To Diversify
Fiduciary rules require that modern portfolio theory should be used and all of a client's assets should be considered in an investment strategy.  This is particularly important when clients have concentrated stock positions or closely held businesses.

For example, if an executive has a large stake in the company that employs him, then the balance of his portfolio should be substantially more conservative than that of other investors since his income is dependant on market performance. In this case, fixed compensation is equivalent to a bond issued by the executive's employer and his annual bonus is comprised, often in large part, of restricted stock and options in the same company, whose fortunes are tied to the markets.  In cases such as these, it is impossible to reduce exposure to the company until after the client has stopped working at the firm.