Sunday, Jun 26

Is the Prudent Man wiser than the Prudent Investor?

Is the Prudent Man wiser than the Prudent Investor?

To start with, this is not a play of words or the interchanging of terms to create fun. The Prudent Man and Prudent Investor are the concept of investing trust assets and have shaped investment trends going back several years. It all started way back in the 1830s due to a dispute between beneficiaries of a trust fund and the trustee who was mandated to manage the trust assets. To understand how the ideas evolved over the years to provide guidance for investment advisors managing funds on behalf of a trust or clients in general and what the Ghanaian investor can learn from them, we need to go back into time…

Once upon a time in in the year 1830, a case was brought in front of a Massachusetts court involving a dispute between the Harvard College, one of the beneficiaries of a trust fund and Mr. Amory, the trustee who was accused of mismanaging the assets of the trust because the fund lost some of its value. I am sure most people would wish to seek redress in court when they find themselves in similar situation. The trustor was John McClean, a rich man who lived in the United States and before he died in October 1823 he selected a Trustees to manage his assets to take case of his wishes after death. At the time of his death John McClean’s estate was valued at $228, 120, which in today’s dollar will be equivalent to about $3.2 million, some of which were invested in financial assets. There was $100, 800 which was invested in manufacturing stock, $48, 000 was in insurance company stocks, $24, 700 was invested in banking stocks and the rest were in real estate, personal items and cash. Mr. McClean was investing in stocks in 1823!

He left his wife some money and real estate property but what really brought the issue that had to be settled in the Massachusetts court was a bequeath he made to Jonathan and Francis Amory to be held in trust. The instructions given to the two trustees were direct and specific: they were to invest or lend the money in “safe and productive stock” either in the public funds, bank shares or other stock, according to their best judgment and discretion. The income generated from the trust fund was to be paid to his wife, Ann, in either quarterly or semi-annual distributions and on her death the trust fund was to be divided among charitable beneficiaries. Half of the trust assets was to go to the Harvard College and the other half was to be given to the Trustees of the Massachusetts General Hospital for charitable purposes. To keep the story short, the trustees invested the trust funds as instructed and in 1828 Mr. Francis Amory, the surviving trustee tended his resignation. Unfortunately for him, at the time of his resignation the trust had lost some money and the current value was less than what the fund started with. The beneficiaries of the trust: Harvard College and the Massachusetts General Hospital were not happy with the loss of value and so sued Mr. Amory claiming he had invested the money in risky companies to provide a high income for Mr. McClean’s widow and disregarding their interest as a remainder beneficiaries. We all hear stories about investors losing money in Ghana by investing in risky assets but I have not heard of any of them seeking redress in a court of law like these beneficiaries did. I have heard stories of investors threatening their advisors with dangerous weapons after their investments went south.

The court’s ruling and what ensued afterwards brought about what has come to be known as the Prudent Man Rule. The court sided with the trustees with the reason that they followed the instructions of the trustor and Justice Samuel Putnam, the justice handling the case, in his famous ruling stated that: “All that can be required of a trustee is, that he shall conduct himself faithfully and exercise a sound discretion. He is to observe how men of prudence, discretion and intelligence manage their own affairs, not in regard to speculation, but in regard to the permanent disposition of their funds, considering the probable income as well as the probable safety of the capital to be invested”. This came to be known as the Prudent Man Rule and was used as a legal basis for settling any issues related to trust and pension fund investments. Let us reduce the legal jargons and look at the meaning of the rule in layman’s language so all of us can get our heads around it. The rule means that if given discretionary control over someone’s asset, you must only invest in risky assets that a person of reasonable intelligence would consider wise, and that the investment has low probability of losses. Which means that you need to invest in low risk assets, judge each investment in a portfolio on its own merits and maintain sufficient liquidity to satisfy the needs of the beneficiaries.

The Prudent Man Rule will be the most ideal guide for the average Ghanaian investor given their low risk tolerance and a love for income generating investments. This limits the investor’s choices to fixed income securities, mainly government treasuries and dividend paying stocks. Being risk averse is not a bad thing in itself but to invest exclusively for income creates inefficiencies in an investment portfolio and limits its growth potential given that the investment industry has moved away from income return to a total return concept.

The prudent man rule served the investing public very well

in the past and provided a guide for investing trust and pension assets but as investment knowledge developed and investment products became more accessible it became obvious that the rule presented a stumbling block to better investment management. It was realized that the Prudent Man was not that wise when it came to investing assets in the modern era.

The first problem with the rule was the requirement to assess an investment risk on a standalone basis. This flew in the face of looking at a security’s contribution to the overall risk and return of a portfolio. What the rule could not anticipate was the effect of correlation on portfolio risk because you can have two risky securities on a standalone basis but when combined into a portfolio the total risk will actually be reduced especially when the correlation of their returns are low. One of the most difficult things to do is to try and convince a Ghanaian investor to put money into a risky asset and even more challenging explaining to him that you can reduce your investment risk by investing in two risky assets. The second issue with the Prudent Man Rule was its concentration on investing in securities that provide income for the beneficiaries. Investing for income is appropriate for those advance in age and who require a sustainable income. The same investment approach will not be appropriate for young investors who need to invest for growth. When an investor concentrates more on income portfolio growth suffers and without growth the portfolio will not be able to keep up with inflation in the long run. I know of the bird-in- hand argument because interest and dividend are cash but in the long run the growth in portfolio value is negatively affected when there is a concentration on income return. I wish I could repeat the last sentence because I have had numerous discussions with prospective Ghanaian investors and all they are interested in is to get interest income and dividend even if it will be detrimental to their portfolio in future.

 

JUNE AUGUS EDITION 111 copy 1

The rule also gave protection to trustees or investment managers who obtain unimpressive investment results so long as they invest in “prudent” securities. The rule said as a trustee, you should look to how men of prudence and intelligence handle their affairs. What was not apparent when the judgement was given by Justice Putnam was that there was to come a whole advancement in investment knowledge that makes it unwise to only look at preservation of capital and income generation as the sole objective of an investment portfolio.

The advent of modern portfolio theory and the advancement in finance and portfolio management led the investing public to realize that the prudent man was not wise after all when investing in the modern world. This led to modifications of the Prudent Man Rule over the decades to what became known as the Prudent Investor or Prudent Expert rule. The new rule had five underlying principles but I will just limit my discussion to three of the principle: diversification, risk versus return and income versus growth.

The new prudent investor rule stresses that diversification is fundamental to risk reduction and is therefore required for managing investment portfolio. Rather than taking very little risk as indicated by the Prudent Man Rule the trustee or investment manager needs to invest in securities that have low correlation and therefore will provide a reduced overall risk for the portfolio.

The new rule also states that risk and return are directly related and therefore the trustee or manager needs to set an appropriate level of risk that will suit the purpose of the investments. That means an investor cannot demand a high return and not be prepared to take an appropriate risk to attain those returns. The prudent investor rule also require a conscious balance between income and growth. What this means is that when managing a portfolio for younger investors or beneficiaries the focus should be more on growth than on income and for older investors the opposite case will hold. Most investors in Ghana hold portfolios that have asset allocations similar to retirees which is mainly concentrated in fixed income securities-mainly government treasury securities.

To answer the question in the title of the article, “Is the Prudent Man wiser than the Prudent Investor”, it is not difficult to notice that due to advancement in investment knowledge the Prudent Investor appears wiser than the Prudent Man and to succeed in the investing game you will need to think like a Prudent Investor. This entails diversifying your portfolio holdings to reduce risk, balance return expectations with appropriate level of risk and invest in securities with growth potential to reduce the negative effect of inflation on an investment portfolio in the long run.

  • There is a big gap on the continent on testing
  • Distributing a million new test kits is still far short of what is needed
  • Africa has so far been hit less hard than other continents by COVID-19 - with 911 known deaths and 3,546 regist...

Social

Copyright © 2022, The Vaultz Magazine. All rights reserved