 |
| > Investing > Fiduciary Focus |
 |
| Fiduciary Focus: The 12 Days of Christmas of a Modern Prudent Fiduciary |
| by
W. Scott Simon
| 12-11-07 |
|
|
On the first day of Christmas my true love said to me: According to Nobel laureate Harry Markowitz, the father of modern portfolio theory, the fundamental problem faced by all investors (including fiduciaries that are responsible for other people's money) is that any investment decisions they arrive at are made under conditions of uncertainty.
On the second day of Christmas my true love said to me: The "central consideration" of fiduciaries under the Uniform Prudent Investor Act (UPIA) (as well as the variations thereof adopted by 44 states, the District of Columbia and the U.S. Virgin Islands) and the Employee Retirement Income Security Act is to determine the trade-off between risk and return in a portfolio.
On the third day of Christmas my true love said to me: The relevant unit to which fiduciaries must pay attention is the investment portfolio, not the individual components that comprise a portfolio.
On the fourth day of Christmas my true love said to me: Investment prudence, according to standards of modern fiduciary investing, is measured by process. Process is how a fiduciary does something, not what happened (i.e., good or bad investment performance) after the fiduciary did it. The prudence of that process is determined by reference to fiduciary conduct, not the investment performance of the portfolio for which the fiduciary is responsible. Stated more expansively, the prudence of fiduciary investment decisions and actions is tested not by the investment performance of a portfolio but by the soundness of the decision-making process that led to the performance.
On the fifth day of Christmas my true love said to me: Focusing solely on return - as most active investors that are stock pickers, market timers and track record investors attempting to beat the market are wont to do - violates the "central consideration" of all modern prudent fiduciaries: determine the tradeoff between risk and return in a portfolio.
On the sixth day of Christmas my true love said to me: It's silly to think that active investors can achieve investment returns superior to that of the market when any investment return is nothing more than a random variable and therefore subject to inherent uncertainty, over which no one has any control. My true love reminded me that focusing solely on return defines investment prudence in terms of portfolio performance, not fiduciary conduct which is directly opposite of how standards of modern fiduciary investing define prudence: in terms of fiduciary conduct not portfolio performance.
On the seventh day of Christmas my true love said to me: Broad diversification of the risk in a portfolio increases return. To enhance that return, diversification should occur at two levels: both across (i.e., horizontally) the asset classes that comprise the portfolio and within (i.e., vertically) each such asset class.
On the eighth day of Christmas my true love said to me: Prudent fiduciaries should adopt a prospective view of risk which obliges them to recognize consciously - before implementation of a given portfolio investment strategy - the fundamental problem identified by Professor Markowitz on the first day of Christmas. Because uncertainty implies risk, a common way of managing the problem described by Professor Markowitz is to diversify the risk in portfolios as broadly as possible.
|
|
1
|
2
 |
|
|
|
| W. Scott Simon is an expert on the Uniform Prudent Investor Act and the Restatement 3rd of Trusts (Prudent Investor Rule). He is the author of two books, one of which, The Prudent Investor Act: A Guide to Understanding is the definitive work on modern prudent fiduciary investing. Simon provides services as a consultant and expert witness on fiduciary issues in litigation and arbitrations. He is a member of the State Bar of California, a Certified Financial Planner, and an Accredited Investment Fiduciary Analyst. Simon's certification as an AIFA qualifies him to conduct independent fiduciary reviews for those concerned about their responsibilities investing the assets of endowments and foundations, ERISA retirement plans, private family trusts, public employee retirement plans as well as high net worth individuals. For more information about Simon, please visitPrudent Investor Advisors, or you can e-mail him at wssimon@prudentllc.com The author is not an employee of Morningstar, Inc. The views expressed in this article are the author's. They do not necessarily reflect the views of Morningstar. |
|
|
|
|
|
 |
|
Manager's View Participants
|
|
|
|
|
|
|
Follow us on Twitter
