The so-called "Prudent Man Rule" defined how someone was supposed to invest when they were charged with managing Other People’s Money. The term "fiduciary" today describes 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 concept has been around for a long time. It goes back to the court case in 1831, Amory vs. Harvard College, which ruled that a fiduciary should act as "any prudent man." So the two terms became intertwined at that point.
Before the '60s era of investment funds that reflected personalities such as Peter Lynch or Gerry Tsai running what were considered "go-go funds," the prudent man rule pretty much ruled the world of money management. The general idea was that you invested in the largest 200 companies with about two thirds of the money in the fund and stuck the remaining third in bonds.
Even today, this approach is time-tested. 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. It’s like an insurance policy costing 1 percent that reduces your possible loss by about one third of what it otherwise would have been with 100 percent in stocks. A fifty-fifty 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, and for a reality check, we can look at the stock/bond mix of almost all mutual funds describing themselves as being of the "balanced" persuasion. 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, thirty 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 hand-written 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 their $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."