What Is a Prudent Investment?
A prudent investment refers to the recognized 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), whom an investor entrusts to make prudent investments, should make certain that a chosen investment makes sense within their client's overall portfolio and that fees will not detract significantly from the investment's returns.
- A prudent investment refers to the recognized use of financial assets that are suitable for an investor’s goals and objectives.
- Good fiduciaries monitor the performance of the investments they have selected 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.
How Prudent Investment Works
Good fiduciaries monitor the performance of the investments they have selected 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.
The prudent-person rule (formerly known as the "prudent man rule") is a legal maxim restricting the discretion allowed in managing a client's account to the types of investments that a prudent person seeking reasonable income and preservation of capital might buy for his or her own portfolio.
Investors can increase the likelihood of making a prudent investment by following these three recommendations:
- Diversifying asset classes: Investors can reduce the overall volatility of their portfolios 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 portfolios 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 fees and commissions. Exchange-traded funds (ETFs) allow investors to purchase a portfolio of selected stocks without paying a commission for each trade. (For more, see this Q&A: What are the best ways to lower my investment fees?)
Prudent Investor Rule Example
If a financial planner advised a 70-year-old client to invest all of her money in a single stock, it 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 as the investor approaches retirement age.