Risk Management and the Prudent Investor Rule

Abstract

The prudent investor rule, now enacted in every state, is the centerpiece of trust investment law. In accordance with modern portfolio theory, the rule directs a trustee to implement an overall investment strategy having risk and return objectives reasonably suited to the trust. This article, recently published in Trusts & Estates magazine, summarizes the results of an earlier empirical study of the effect of the rule on asset allocation and management of market risk by bank trustees. We had two main findings. First, enactment of the rule was associated with increased stockholdings by bank trustees, but not among banks with average trust account sizes below the 25th percentile, a result that is consistent with sensitivity in asset allocation to trust risk tolerance. Second, enactment of the rule was associated with increased portfolio rebalancing by bank trustees, a result that is consistent with increased management of market risk. Given these findings, we concluded that reallocation toward additional stockholdings after enactment of the rule was correlated with trust risk tolerance and that the increased market risk exposure from those additional stockholdings was more actively managed.

Keywords: prudent man rule, prudent investor rule, trust investment, fiduciary investment, prudent investor, modern portfolio theory, agency costs, fiduciary, fiduciary duties, risk tolerance, rebalancing, portfolio management

JEL Classification: G11, G28, K11