The Prudent Investor Blog

5 Key Principles for the Prudent Investor

Posted by Benjamin Coakley on Thu, Aug 30, 2012 @ 12:51 PM

A measure contained in section 404(a)(1)(B) of the Employee Retirement Income Security ActPrudent investor (ERISA) that requires the fiduciary of a defined contribution retirement plan to use "care, skill, prudence and diligence", and to act in the same way that someone "familiar with such matters" would act. The "familiar with such matters" language has been interpreted to mean "expert". This language creates an important distinction from the earlier prudent person guideline, in that it holds fiduciaries to a stricter standard.

A fiduciary is someone who is legally responsible for someone else's money, and who is legally required to manage that money in the best interests of its owner. Fiduciary best practices include identifying the client's time horizon, desired return and risk tolerance, choosing asset classes consistent with these guidelines, periodically reviewing investment performance and periodically reevaluating whether fiduciary standards are being met. 

If you asked any investor if they wanted to be “prudent”, most would answer yes.  A Prudent Investor evaluates investment decisions based on key principles.  These “Key Principles” are:

  1. The Economy is Unpredictable- Therefore, no one can accurately predict interest rates, stock prices, market fluctuations, etc.
  2. Markets Work-Capital markets do a good job of fairly pricing all available information and investor expectations about publicly traded securities.
  3. Diversification is Key-Comprehensive, global asset allocation can neutralize the risks specific to individual securities.
  4. Risk and Return are Related-The compensation for taking on increased levels of risk is the potential to earn greater returns.
  5. Structure determines performance -The asset classes that comprise a portfolio and the risk levels of those asset classes are responsible for most of the variability of portfolio returns.

Are you a “Prudent Investor”?  If so, you are must also educate yourself as a “Prudent Expert”.  You should also hold your advisors to this “Fiduciary Standard”!

Tags: prudent investor, investing