Prudent Investment

DEFINITION of 'Prudent Investment'

A prudent investment refers to the use of financial assets that are suitable for an investor’s goals and objectives. A prudent investment considers the risk/return profile and the time horizon of an investor. Fiduciaries (such as financial advisors, attorneys, CPAs and retirement plan sponsors) who an investor entrusts to make prudent investments should also ensure that the investment makes sense within their client's overall portfolio and whose fees do not detract significantly from the investment's returns.

BREAKING DOWN 'Prudent Investment'

Good fiduciaries monitor the performance of the investments they have chosen for their clients to make sure they are achieving their stated goals. The Prudent Investor Rule specifies that fiduciaries must make sound money-management decisions for their clients based on the information available. The outcome of their investment decision, whether good or bad, is not a factor in whether the investment is considered prudent.

Prudent Investor Rule Example

Suppose a financial planner advised their 70-year old client to invest all of his or her money in a single stock, this would not be considered a prudent investment, even if the stock skyrocketed in value and the investor sold at just the right time to make a substantial profit. It is an imprudent investment because putting all of the investor’s money into a single stock is a risky strategy, especially if they are approaching retirement age.

How to Make Prudent Investments

Investors can increase the chances of making a prudent investment by:

  •  Diversify asset classes: Investors can reduce the overall volatility of their portfolio by investing in different asset types. For example, Mark’s portfolio may consist of stocks, bonds, commodities, cryptocurrency and forex. If stocks are in a bear market, Mark’s losses may get offset by gains in his cryptocurrency holdings. It is prudent for investors to allocate a smaller proportion of their portfolios to riskier assets, such as small capitalization stocks and commodities.

  • Rebalancing: Prudent investing requires investors to rebalance their portfolio periodically. For instance, if the stock component of Jennifer’s portfolio increases from 40% to 65% after a year of consistent gains, it is prudent to reduce her stock holdings back to 40% by selling some of the excess returns and purchasing other asset classes that are currently out of favor.

  • Minimizing fees: Prudent investing involves reducing the fees and commissions charged. Exchange-traded funds (ETFs) allow investors to purchase a portfolio of selected stocks without paying a commission for each trade. (For more, see: What are the Best Ways to Lower My Investment Fees?)