The so-called Prudent Man Rule defines how someone is supposed to invest when they are charged with managing other people's money. This rule applies to what's known as a "fiduciary," someone who presides over a managed pool of money and who is legally obligated to act in the sole interest of the beneficiaries of that money.
The Prudent Man Rule has been around for a long time. It goes back to the 1831 court case Harvard College v. Amory, which ruled that a fiduciary should act as "any prudent man."
The Prudent Man Rule pretty much rules the world of money management. The general idea is that you invest in the largest 200 companies with about two-thirds of the money in the fund and stuck the remaining third in bonds.
Almost all mutual funds described as balanced funds adopt this two-thirds/one-third allocation because it capitalizes on the inevitable growing economy while protecting against downdrafts to at least some extent (thanks to the bond portion). While a total stock portfolio including reinvested dividends can be expected to earn roughly 10 percent per year on average, the addition of the bonds reduces the expected overall return to 9 percent. But think of that 1 percentage point differential as an insurance policy, since the two-thirds/one-third split reduces your possible loss by about one-third of what it otherwise would have been with 100 percent in stocks. A 50-50 mix reduces average returns to about 7.5 percent without offering that much more downside protection.
These results have been largely time-tested over the years, which is why most balanced funds have gravitated toward that split. Lo and behold, they all have the same two-thirds/one-third mix of stocks to bonds. The reason: They all compete with each other for performance, and they know that a 9 percent long-term average result is what sells. People prefer performance over protection -- just like with cars.
Getting back to Harvard and the 1831 court case, the college sued Amory, who had managed money in a trust that was ultimately destined for Harvard after the beneficiaries had died. Contending that they had lost some of what should have been theirs, Harvard sued but lost because the trustee had, in fact, managed the funds prudently. Even with the right decisions, bad timing and soft markets can cause losses to occur.
The case involved about $50,000, which, 30 years before the Civil War, would have been a lot of money. The short story "Bartleby, the Scrivener" by Herman Melville comes to mind as I picture a room full of men keeping track of stocks, bonds, dividends and interest in handwritten journals during that era.
Today my alma mater is back in the news. Harvard should probably be suing someone again for disastrous results over the past several years in its $30 billion endowment fund. Enticed into a world of private equity, interest rate swaps, alternative investments like forests and other "next big things," the college posted a gain of just 1.7 percent in the year that ended in June 2013. Hardly the stuff of "Prudent Man" legend. Most 401(k) participants generated better results. Meanwhile, the top six managers of the fund earned a combined total of $30 million per year.
The lesson here is that managing money effectively is easy and straightforward. With a few exceptions, bright stars in money management tend to flame out sooner or later. It's hard to know prospectively who those exceptions are, so don't bother to try. Instead, just adhere to the basics of diversification, low fees, and patience. It's that simple. As for Harvard and its financial problems, I'm reminded of Richard Bissell's great book, "You Can Always Tell a Harvard Man ... But You Can't Tell Him Much."
Steve Butler can be reached at 925-956-0505, ext. 228. His email is firstname.lastname@example.org.