This begs the question: What can a registered representative legally and ethically do with her discretionary authority? The answer is governed by the Prudent Man Rule which dates back to an 1830 Massachusetts civil court ruling stating that: "a fiduciary shall exercise the judgment and care, under the circumstances then prevailing, which men of prudence, discretion, and intelligence exercise in the management of their own affairs, not in regard to speculation but in regard to the permanent disposition of their funds."

Historically, this has been interpreted strictly, with preservation of capital apparently construed as the only goal of someone with a fiduciary responsibility. However, there is a couple of obvious problems with this:

  • First, people who have trusted their financial decisions to another are not necessarily in the phase of life in which capital preservation ought to be their primary objective. Many of these account holders are minors, who should have their portfolios managed for growth rather than income - a goal which requires taking on more risk than the Prudent Man rule, with its "not in regard to speculation" language, apparently allows.

  • This brings up the second problem: portfolio analysis. You have already seen that options, for example, can be risky on their own but can act as a virtual insurance policy when viewed as part of a portfolio. The Prudent Man Rule, as historically interpreted, looks at investments on an individual basis and does not consider how risks in a portfolio net out.

As a result, accounts over which a third party has discretion have not produced the level of returns that they otherwise could.

Transformation of the Rule
Over the past few decades, the Prudent Man Rule has undergone a transformation and has morphed into the less archaic-sounding Prudent Investor Rule, or Prudent Expert Rule. Fortunately, there is more to the change than just political rectitude.

According to ERISA, the definition of the standard of care was expanded to include: "... that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims ... by diversifying the investments of the plan so as to minimize the risk of large losses [italics added] ..." By specifying that the fiduciary must act in a way familiar with financial markets and that diversification is a good thing, this update of the old Prudent Man Rule frees the individual who exercises her discretion over another's account to make more rational choices.

Muddying the waters, however, is the fact that an individual state might have its own interpretation of prudence that must also be followed by registered representatives doing business there.


Look Out
The Series 7 exam might not include specific questions about the Prudent Investor Rule simply because it is still a work in progress. What is important to know is that, regardless of the standard, the fiduciary who incurs losses in violation of the rules is personally liable to restore those losses. It is also important to know that, unless otherwise specified in a market order, the timing and pricing of an individual transaction is completely up to the discretion of the registered representative. After all, that is your job.


Opening a Brokerage Account

Related Articles
  1. Financial Advisor

    The Fiduciary Rule and Life Insurance: Use Caution

    The rules pertaining to life insurance under the DOL's fiduciary rule remain murky.
  2. Retirement

    What You Should Know About the New Fiduciary Rule

    These key questions and answers clarify the DOL's new fiduciary rule and how it impacts individual investors saving for retirement.
  3. Financial Advisor

    Meeting Your Fiduciary Responsibility

    Being a fiduciary comes with a certain level of responsibility. These four steps will reduce your liability when managing other people's money.
  4. Insights

    How the New Department of Labor Rule Impacts You

    There are both positives and negatives to the new DOL rule regarding fiduciary responsibility.
  5. Financial Advisor

    How Trump Could Repeal, Soften Fiduciary Rule

    Donald Trump has threatened to repeal the new fiduciary rule. Here’s what he could do if he wants to kill the rule in its present form.
  6. Financial Advisor

    Indie BDs: Trump Should Drop the Fiduciary Rule

    A majority of independent broker-dealers want Trump to repeal the fiduciary rule, a recent survey reveals.
  7. Financial Advisor

    Why Fiduciary Rule is Good News for Small Plans

    Under the new fiduciary rule small business owners may be subject to less risk for the plans that they sponsor. Here's why.
  8. Personal Finance

    The Fiduciary Rule Is Here, Sort of

    The fiduciary rule finally took effect June 9th, though this is only a partial implementation.
  9. Financial Advisor

    Can Trump Roll Back the Fiduciary Rule?

    Donald Trump's improbable election and support for scaling back government regulations means that the DOL fiduciary rule could come under threat.
  10. Financial Advisor

    How Trump Could Let the Fiduciary Rule Die on the Vine

    If Donald Trump keeps his promise to repeal the fiduciary rule his administration could do so by not defending it against pending lawsuits.
Frequently Asked Questions
  1. How did the ABX index behave during the 2008 subprime mortgage crisis?

    Read about the disastrous performance of the various ABX indexes in the subprime mortgage crisis of 2008 during the middle ...
  2. How did moral hazard contribute to the 2008 financial crisis?

    Learn about moral hazard, how it can affect outcomes and how it contributed to the conditions that led to the 2008 financial ...
  3. Which mutual funds made money in 2008?

    Read about the only mutual fund that turned a profit in 2008. Learn about risk-averse investment strategies and the financial ...
  4. Were Collateralized Debt Obligations (CDO) Responsible for the 2008 Financial Crisis?

    Collateralized debt obligations are exotic financial instruments that can be difficult to understand, Learn the role they ...
Trading Center