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The Prudent Man


A Minyan wrote me yesterday with the following:

I am the trustee for my children's trust. There is also a "corporate" co-trustee as required by the Trust, which happens to be a bank. I have had the assets in cash equivalents for quite some time.

I had a meeting last week with the bank. I have been advised that under the "Prudent Man Rule" I must buy stocks and can't sit in cash; I must diversify. I have out performed these people, not that I lost less than them, but have not lost period (I did not get caught in the 2000 - 2002 stock market decline). This does not seem to matter to them. They gave me that garbage about fiduciary obligations: I am supposed to own stocks and even if I lose money that is okay because I am not sitting in cash. The bank can't be sued for losing my money, but I think they worry that they can if the trust doesn't own stocks. I won't even burden you with the stocks they said to purchase.

Is this what qualifies as money management? Since when is putting assets at risk because of some Prudent Man Rule or the threat of a lawsuit a viable investment theme? This is the stance of a firm that has lost people money and is still probably only back to where they started 4 or 5 years ago despite the rally of 2003.

This first hand frustration says a lot about how Wall-Street, through lobbyists (the fall of Glass-Steagle) and psychology, has geared the game in their favor. Wall-Street revenue streams from retail commissions to investment banking fees are critically dependent on a rising stock market. Convincing the public to have a significant allocation to equities is essential.

For example, the mutual fund industry is a clever product of this machine: it creates a disconnect between the ultimate investor (you and me) and the investment decision. This disconnect is an important psychological variable in "cajoling" the public into having too high of an asset allocation in equities.

Any "prudent man rule" is a non-sequitur: every person should be free without restriction to decide how to structure their savings and investments. Every one is unique in both risk tolerance and financial objectives, so a standard rule like this is very dangerous.

First of all in deciding how much money to put into stocks we have to answer the question what is capital? If a person has a large amount of debt through a mortgage so that her net worth is solely based on the price of her house, what is her real capital? You could argue that it might really be zero; in that case, how much of this borrowed money should she have in the stock market?

A better way to allocate assets is to analyze the "Value at Risk". Yesterday I introduced something called "optimal f". This approach makes the investor understand the likelihood of loss versus return and apportion assets according to "acceptable loss".

Secondly, the statement that, "stocks have returned 7-8% annually over the last fifty years," is pure rhetoric. Advising a "mandatory" allocation to equities based on past historical data, especially over long periods of time, is statistically a weak argument because it is linear in nature. I would argue that markets are actually non-linear in nature: one single event or a series of events can affect markets at first in a small way, but then those effects can build over time. For example, what if the U.S. had lost WWII? Or what if Reagan's gambit with the Russians had backfired? Or on a smaller scale, what if quantum physics had not been developed and the micro chip had not been invented? Or maybe it was just that Japan invented them. Do you think that stocks over the last fifty years would have been the same type of investment?

Because these events turned out positive in the distant or recent past, stocks have performed in a certain manner. But the causes cannot be linearly extrapolated into the future.

Too heavy of an allocation to risky assets like stocks, as recommended by Wall Street, often causes investors to sell at market bottoms, while a lower allocation to risky assets might allow them to hold on to these risky assets and "weather the storm".

And now the government is in on the act, knowing how the importance for economic "health" (or survival) has shifted out of necessity from income generation to wealth. By keeping interest rates artificially low they strongly encourage investors to take more risk. This drives up stock prices and supports more debt, a vicious cycle that has no end in sight.

There will be a few that resist the temptation to go along with the crowd, to be more conservative than Wall Street advises or that government policies encourage.

I hope the Minyan above does.

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No positions in stocks mentioned.

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