Fiduciary Responsibility. Fact or Myth?

One of our
top financial journalists frequently tells readers that there has never
been a 20-year period in US history during which the stock market ended
lower than it began.  That's her way of encouraging investors to ride
out bear markets, not to panic by dumping investments at what is likely
to be a bad time, and to remain invested over the long haul.

almost universal advice that we hear today is to diversify, allocate assets,
buy and hold, markets always recover, and investing in the stock market
has proven to be a better investment method than any other (over the

don't have any specific arguments with the goals of encouraging the investing public to save and invest on a regular basis.  My quarrel is
with the advice itself.  Each of those ideas listed above fits in with
the idea of following the 'prudent investor rule.'

According to Wikipedia, The Prudent Man Rule dates back to 1830 and directs trustees "to observe how men of
prudence, discretion and intelligence manage their own affairs, not in
regard to speculation, but in regard to the permanent disposition of
their funds, considering the probable income, as well as the probable
safety of the capital to be invested."

the Prudent Man Rule, speculative or risky investments must be avoided
and a fiduciary may not be held liable for a loss in one investment, as
long as the portfolio, as a whole, satisfies the rule.

Does the Prudent Man Rule require updating?

Does this rule achieve it's main purpose, or does it represent a legal shield for financial advisors?

me, it's clear.  This rule protects financial planners and advisors, and serves no other purpose.  Anyone who has a fiduciary responsibility to take action that benefits the customer [as opposed to Wall Street tradition of making sure that it's the fiduciary who is well cared for by charging sufficient fees and commissions], can simply tell the arbitration panel, which is already biased in favor of the advisor, that the customer was diversified and that asset allocation had not been ignored.  It becomes difficult for the customer to find basis for a reimbursement of losses – because the fiduciary acted in accordance with the prudent man rule.  Even if one or two absurd investment choices (for that specific individual's goals) were made, the defense is that the portfolio, as a whole, met the intent of the rule.  And that defense protects the advisor who failed to act in the best interests of his/her client . 

There is nothing that is not right about this rule, especially because the world had changed.  it's not 1830 anymore. Fiduciaries ought to learn how meet their legal and moral obligations.  And the ostrich  philosophy of fearing to learn or recommend anything new must be replaced.


1) If the market is higher twenty years from now, but is only higher by 5%, how is that going to do anyone any good?  If, at the end of that 20-year period, you are anywhere near retirement age, what are you going to do for money if your assets were in the stock market?  OK, maybe you diversified and had money elsewhere.  Still, the money you counted on being there may not be there.  I don't like advice to buy and hold when it's based on the assumption that all will be well – eventually.  We each face the decision of whether to retire only once per lifetime.  It does you no good to know that there was a 95% chance the money would be there when you needed it.

2) Diversification makes sense, but sometimes all assets get pounded at the same time.  2008 was such a year.  There must be a better method for protecting assets.

3) Asset allocation is another form of diversification.  Again, it's sensible.  But is it enough for an advisor to buy some gold, stocks and bonds and consider the fiduciary responsibility has been fulfilled?   I vote 'no.'

What can be done?  What must pros do for their clients?

I'm not out to change the whole world.  But as far as stock market investing is concerned, there's no reason why the prudent investor should not be protected by choices that evolve over time.  Why doesn't the law demand that the pros who handle other people's money learn to protect an investors assets so that the investor never has to suffer trough another incident such as the bursting of the technology bubble in 2000, or the market decline of 2008?

Large losses can be prevented.  And that does not require the investor's assets be held in cash or equivalent securities.  The methods are neither difficult to learn nor costly.  But it does require that advisors make an effort.  Is that too much to ask?  They collect their fees – is it too much to ask them to earn those fees?

The answer to a significant part of the problem is 'options.'  There is simply no excuse for options to be thought of as being risky investment tools.  There is no excuse for fiduciaries not to adopt risk-reducing option strategies when advising individual investors.  And risk reduction is not the only goal.  There is plenty of opportunity for making money.  Profits are not ignored, but for some clients, preservation of assets must take priority and earning additional money can play a still important, but secondary role.

Options have been exchange-traded for more than 36 years and yearly volume has been exploding.  These tools are not just for hedge funds.  They can be used by many millions of investors worldwide.  I agree that options are not for everyone, but there's no excuse for not learning about alternative investment choices, and what they can do for you.  Once you have learned for yourself, or after your financial advisor has carefully and completely outlined how options are used – then you can decide whether to take advantage of the special properties of options.  Today the attitude among the professionals is (apparently) that it's just too much effort.  And many, in their ongoing ignorance, make no effort to learn for themselves – just in case they may discover something useful for clients.  The truth is that they don't dare.  Lose money with something new and better, and you get sued.  The prudent man law must be changed and brought into the 21st century.


4 Responses to Fiduciary Responsibility. Fact or Myth?

  1. Manshu 06/27/2009 at 4:08 PM #

    If all an adviser is doing is telling you to buy a diversified fund and holding it for years, then you don’t need to pay him. You can pretty much do this yourself.
    There is no reason for advisers to not use options or other strategies, which might be difficult for an individual investor to learn and apply.

  2. Mark Wolfinger 06/27/2009 at 6:31 PM #

    Hi Manshu,
    I agree that advisors must do more than offer bland information.
    The stumbling block is that the advisor (I prefer this spelling, but both are commonly used) cannot hold the client’s hand and make all the trades. And for many individual investors, learning how options work – and then making the trades – is something that is simply not going to happen.
    Yet I want to see more people begin to trust the idea of using options conservatively. I envision someone launching a family of alternative funds for passive investors: The standard portfolio mimics the performance of a major index – but the funds differ because each collars a different percentages of the portfolio (25, 50, 75, 100%).
    Additional refinements to the collar strategy are possible, such as how far out of the money the puts should be. That changes the insurance policy’s deductible. The strike price of the call can be chosen to make the fund more (or less) bullish.
    I’d like to see some progress – at least it would be progress to me – along these lines.

  3. Sigma Options 06/28/2009 at 6:32 AM #

    It’s a good article Mark which in principle I entirely agree with.
    The key is competency, this could be a problem. Could it be opening a can of worms? That would be my concern.

  4. Mark Wolfinger 06/28/2009 at 9:32 AM #

    It’s a valid concern. One could not expect the professional advisor to make the trades for each client, nor would each client be ready to make the trades for his/her account.
    I’m so much in favor of individuals being able to protect an investment portfolio than I nave not concentrated on who would manage the account. A great many people can do it themselves, but far too many have neither the time nor inclination to learn the required skills.
    That’s the basic reason why I’m looking for a mutual fund company to offer the necessary index funds that are partially collared.