Five New Criteria for Prudent Investing
By Mitchell S. Ostwald

While the financial markets continue to baffle both professionals and investors alike, the issue of proper diversification within a portfolio becomes a hot topic. In recognition of the importance of diversification in a portfolio, the National Conference of Commissioners on Uniform State Laws approved and recommended for enactment in all the states the Uniform Prudent Investor Act ("UPIA").

In explaining UPIA, its drafters stated that "it undertakes to update trust investment law in recognition of the alternations that have occurred in the investment practice. These changes have occurred under the influence of a large and broadly accepted body of empirical and theoretical knowledge about the behavior of capital markets, often described as 'modern portfolio theory'. "

The UPIA made five fundamental alterations in the former criteria for prudent investing.

1.
The standard of prudence is applied to any investment as part of the total portfolio, rather than to individual investments. In the trust setting, the term "portfolio" embraces all the trust assets.

2.
The trade off in all investing between risk and return is identified as the fiduciary's central consideration.

3.
All categoric restrictions on types of investments have been abrogated; the trustee can invest in anything that plays an appropriate role in achieving the risk/return objectives of the trust and that meets the other requirements of prudent investing.

4.
The long familiar requirement that fiduciaries diversify their investments has been integrated into the definition of prudent investing.

5.
The much criticized former rule of trust law forbidding a trustee to delegate investment and management functions has been reversed.

The Prudent Investor Rule has been adopted by the State of California. It is updated from time to time based upon the work of the Commission.

It is important to note that diversification is a major part of UPIA. Another way of putting it, diversification is necessary for prudent investing. In fact, the 1990 Noble Peace Prize was awarded to Harry Markowitz for his explanation of this phenomenon. It is important to have one's portfolio stocks that do not all depend on the same economic variables, such as consumer spending, business investment, housing construction and so forth. Experts generally agree that it takes at least 10, usually 15-20, non-correlated stocks to achieve adequate diversification and thereby reduce non-systematic risks.

While the markets continue their summer dulldrums and investors continue to scratch their heads, isn't it nice to know that there are some well recognized theories to apply towards investment strategies regardless of market conditions.

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