Begin with a Prudent Process

Uniform Prudent Processes are Objective

The Uniform Prudent Investor Act (UPIA) defines a process for Prudent investing.  Expert fiduciaries who follow the process correctly make the portfolio management prudent, without regard to subsequent results.

Good Results Do Not Substitute for Good Process

We'd all agree that buying lottery tickets with your 401K money would be imprudent, even if you won. The good results do not justify the incredibly stupid risk that action represents, even if you turned $100,000 into $120 million overnight.

However, investing too much money in bonds will also violate the Prudent investment law, thus it is on par with buying lottery tickets. If you are heavily invested in bonds during a bear market, your portfolio may appear to “beat the market” and “be safer” because of it’s performance. That’s just luck, however. Your bonds won’t outperform a bull market in stocks and over time inflation can work against you over the duration of your retirement. Both of these decisions demonstrate equal imprudence, even though things will work out better with the bond strategy than with the lottery strategy. In short, the law defines prudence and makes everything else imprudent.

No Proper Investments are Inherently Prudent or Imprudent.

Experts have wrestled for centuries over how to invest important money (usually, other people’s money). The “Prudent Man Rule” resulted from a case in 1830 when Harvard University tried to sue a trustee based on the performance of investments chosen for the University’s endowment. The judge ruled that trustees may make investment decisions applying the same standards - reasonable income and preservation of capital - that a prudent man would use.

That standard guided trustees for over a century. Some states created more formal rules, limiting fiduciaries and bank trust departments to a so-called Legal List of approved investments. The Legal List made for easy investing, but the conservative investments often had beneficiaries running out of money before they ran out of the need for money.

Diversification Allows for Volatile Investments in a Prudent Portfolio

Academic research over the last 70 years shows that when managers use statistical principles to choose portfolio components, a blend of volatile assets can make the portfolio safer. The purpose of proper diversification is to lower volatility and achieve market returns after all expenses.

This means that your retirement funds need to be positioned in accordance with the needs of you and your family, not in accordance with a five minute risk tolerance questionnaire.

Risk and Return Analysis: Numbers, not Emotions

Risk and return are so directly related that trustees have a duty to mathematically analyze and make conscious decisions concerning the levels of risk appropriate to the purposes, distribution requirements, and other circumstances of the trusts they administer.

This means that your retirement funds need to be positioned in accordance with the needs of you and your family, not in accordance with a five minute risk tolerance questionnaire. Long term investors distinguish between risk and volatility. Volatility is unavoidable for those who want to live on investment income. On the other hand, your risk tolerance for failure in retirement is exactly zero. You don’t want to do anything that increases your risk of failure. Prudent planning may not succeed in the face of abject disaster, but it represents the best planning available to St. Louis retirees.