Legal Definitions - prudent person rule

The prudent person rule, also known as the prudent investor rule, is a fundamental legal standard that requires individuals entrusted with managing someone else's assets (known as a fiduciary) to act with the same care, skill, and caution that a reasonably sensible and cautious person would use when managing their own affairs. This means that when making investment decisions, a fiduciary must consider both the potential for generating income and the safety of the principal investment, aiming for a balanced approach that protects the assets while also allowing for reasonable growth.

Here are some examples illustrating the prudent person rule:

• Example 1: A Trustee Managing a Child's Inheritance

  Imagine Sarah is the trustee for her niece, Emily, who inherited a substantial sum of money. This inheritance is intended to be used for Emily's education and future well-being when she turns 18. Under the prudent person rule, Sarah cannot invest Emily's entire inheritance in highly speculative penny stocks, even if they promise a very high return. A prudent person managing funds for a minor's long-term future would prioritize the safety of the principal while seeking moderate, reliable growth. Sarah should diversify the investments across safer assets like bonds, blue-chip stocks, and perhaps some real estate, ensuring the funds are available and have grown reasonably by the time Emily needs them, rather than risking significant loss for potentially huge, but uncertain, gains.

• Example 2: An Executor Handling an Estate

  Consider Mark, who is the executor of his late father's estate. The estate includes a portfolio of various investments that need to be managed until the assets are distributed to the heirs. The prudent person rule dictates that Mark must manage the estate's investments responsibly during the probate process. He shouldn't, for instance, sell all stable, income-generating assets immediately to invest heavily in a single volatile cryptocurrency, hoping for a quick profit before distribution. Instead, he should maintain a balanced portfolio, perhaps making adjustments to reduce risk or ensure liquidity for estate expenses, always considering the probable safety and income for the beneficiaries, just as a reasonable person would manage assets intended for others.

• Example 3: A Pension Fund Manager

  A manager of a large company's employee pension fund is responsible for investing billions of dollars contributed by employees for their retirement. The prudent person rule is paramount in this scenario. The pension fund manager cannot take excessive risks with the employees' retirement savings by investing a disproportionate amount in high-risk ventures or unproven startups, even if some promise extraordinary returns. A prudent person managing such critical funds would prioritize the long-term security and stability of the investments, ensuring that there will be sufficient funds to pay out pensions to retirees. This involves extensive diversification, careful risk assessment, and a focus on consistent, sustainable returns rather than speculative gambles.