Prudent Person Rule - Explained
What is the Prudent Person Rule?
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Table of ContentsWhat is the Prudent-Person Rule?How Does the Prudent-Person Rule Work?Application of the Prudent-Person Rule
What is the Prudent-Person Rule?
The prudent-person rule refers to a legal rule which subjects an investment manager or a portfolio manager to make the right decisions on behalf of their clients. Also known as the prudent man rule, this legal law states restricts the discretion which is permitted in overseeing a clients account to the forms of investments that a prudent person that is looking for income and continued safety of capital might buy for his or her portfolio. Simply put, this rule states that a portfolio manager is required to only purchase securities that a person who is considered disciplined would purchase. That is to say, the manager is expected to engage in profitable but low-risk investments on behalf of his clients portfolio.
How Does the Prudent-Person Rule Work?
The prudent-person rule was established to prevent investors from portfolio managers that are looking or actively engaging in high-risk, potential fraud-like investments, as well as questionable investments. Some examples of such investments can include penny stocks, marijuana stocks, or any other type of shady investment which can put a clients capital at unnecessary risk. Priority is placed on the investor, and the prudent-person rule doesn't require a trustee with extraordinary expertise to exert the fiduciary duty of overseeing securities. However, such a trustee is expected to make rational and unquestionable investment choices when managing the financial assets of their clients. They're also expected to make just the best choices, or invest in securities that they can explain the reason why they decided to pick it on behalf of their clients.
Application of the Prudent-Person Rule
The prudent-person rule, although more applicable to a portfolio manager, can also be applied to a person who has been given the right to guardianship or stewardship of a clients estate, who may however be separated, restricted, or unable to provide advice or act on their own behalf. Simply put, the prudent-person rule can be applied to an individual who manages an estate on behalf of someone else, and also takes actions that suits the main owner of the estate, and not based on his own instincts or emotions. For instance, if a person were to administer a pension fund or any other form of trust to a company employee, they will be mandated to engage in investments with the funds which was administered. Also, the investment which they will choose is required to have a potential possibility of high profitability. Here, they cannot be allowed to channel the fund to a high-risk investment which has a low chance of turning in profits. The fund also cannot be channelled to investments that would directly affect the income of the account holder adversely, regardless of whether or not it enriched a third party. For example, if a fiduciary was given control of an estate during a time period that their client wasn't available to direct what investments to jump in and what to overlook or avoid, the prudent-person rule would restrict the fiduciary from putting the clients capital into a high-risk investment that has a low potential of high profitability. While this rule seems to be focused on financial securities, it can also apply to real estate purchases, the process of financing a business, the acquisition of collectibles or any other asset which has no capital value tagged to them. It is critical to note that the rule doesn't require all investments to be lucrative or breed excess returns, or to be correct, but it focuses on restricting managers from entering investments that carry high risks with potentials of low or negative returns. The investment (in the absence of the client) should be made with good faith and in line which what an average or even an unlearned person would deem as an appropriate action. In the Employee Retirement Income Security Act, some of the languages used are comparable to the prudent-person rule, by pushing retirement fund managers and similar assets managers to mitigate the risks in their clients portfolio and prevent large losses on the general return or profit.