Most of us are at least familiar with the premise behind the Golden Rule. Essentially, it states that we are to treat others how we’d want to be treated. When it comes to the relationship between investors and fiduciaries responsible for their savings, though, there’s actually a golden-esque rule on the books – and it’s called the prudent person rule. Here’s a look at what this rule is, what it demands and when the prudent person rule comes into play. Consider working with a financial advisor as you make decisions about how to allocate your financial assets.
Trusting someone else with your hard-earned money can be nerve-wracking. After all, if a financial advisor or estate trustee manages your assets in risky or reckless ways, you could lose out on decades of growth and even derail your plans. That’s why it’s important that your financial manager be a fiduciary, bound to things like the prudent person rule.
Also known as the prudent man or prudent investor rule, the prudent person rule requires fiduciaries to make investment decisions for their clients based on what a reasonable (or prudent) investor would choose for themselves.
This rule originates in the early 1820s, following the death of a wealthy man named John McLean. Mr. McLean left a large portion of his estate to his wife, with the rest to be managed by trusted financial managers. The trustees were later charged with mismanaging the funds and losing a large portion of the investment.
The judge presiding over their court case declared that when it comes to investments, the capital was always at risk. The trustees’ obligation was only to manage the money prudently and with discretion (which they were found to have done), and resulted in what has become the prudent person rule.
The prudent person rule might apply to individuals such as:
According to this rule, these individuals – with whom you’ve entrusted your money and assets – are legally obligated to make decisions that don’t unnecessarily increase your risk of loss or could be deemed irresponsible. Instead, they should treat your money as if it were their own and manage the funds accordingly.
How the prudent person rule plays out depends on what type of fiduciary you’re talking about. For instance, a guardian or trustee should be able to answer for big investment decisions they make. This is true whether these decisions are made on behalf of you or your estate. All financial decisions should be made with full disclosure and be in your best interests, without being reckless or taking on undue risk.
A mutual fund manager’s actions, on the other hand, might not necessarily be judged by each individual investment chosen. Instead, this individual may just be overall expected to diversify your investments to limit loss, maintain liquidity, reject high-risk investments and monitor the fund regularly.
It’s important to note that the prudent person rule doesn’t have to mean that your investment or asset manager is always right, or that your investments always be profitable. Sometimes, in fact, you may very well lose money on an investment or see less growth than expected.
With the prudent person rule, rather, it requires that your trusted fiduciary make decisions with your money that a person of average intelligence might make for his or her own funds. This person should be able to explain why specific investments were chosen or a portfolio managed in a particular way.
So, what if an investment manager or other trusted fiduciary fails to follow the prudent person rule? Well, he or she could possibly be held liable for certain losses that an investor suffers.
Of course, this would depend on the specific situation and whether or not it could be reasonably demonstrated that the losses were the result of the fiduciary’s failure to exercise caution, skill and even reasonable care when investing others’ money. However, financial managers should keep this potential culpability in mind and exercise due diligence.
Today, a relatively small number of states follow the prudent man rule as it was written. Rather, the rule has since adapted to reflect more modern investment habits (like diversification) and overall fiduciary duty standards. Financial managers bound to the prudent person rule are expected to manage investors’ funds and assets with care. This means only choosing prudent investments that they would pick for themselves. While it doesn’t mean that the investments are guaranteed to be successful, investors can rest assured that their assets have the best chance for growth when investing through someone following the prudent person rule.
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