Monday, January 21st, 2019
dear prudence

A variety of laws and regulations are in place to guide those who provide investment advice, direct management, or stewardship of assets on behalf of others.  At the core of them is “the prudent man rule,” which first arose as a concept almost two centuries ago.

But what constitutes prudence?

Arthur Brooks, in a 2017 New York Times opinion piece,New York Times | The printed version was entitled, “Nobody Here But Us Chickens.” questioned today’s most common interpretation of the word.  He wrote, “The connotation of prudence as caution, or aversion to risk, is a modern invention.  ‘Prudence’ comes from the Latin ‘prudentia,’ meaning sagacity or expertise.  The earliest English uses from the 14th century had little to do with fearfulness or habitual reluctance.  Rather, it signified righteous decision making that is rooted in acuity and practical wisdom.”

I quite like “acuity and practical wisdom” as a description for what makes for a prudent fiduciary.The Prudent Fiduciary Digest | I use the term “prudent fiduciary” in the title of a newsletter that I write for institutional asset owners.  You can see all of the issues of it here.  But that’s not the language to be found in the different statutes and standards.  The most often-cited definition comes from the Employee Retirement Income Security Act of 1974 (ERISA), which requires a fiduciary to act “with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims.”U.S. House of Representatives | This is the applicable section of the U.S. Code.

To Jeremy Grantham of GMO, that means that prudent investing “has long been legally defined as doing what others do.”GMO | The quote is from “Ignoble Prizes and Appointments.”  You will need to register (for free) to view it.  Of course, that can be problematic.

In the early days of professional investing you could argue that everyone was being too cautious; very few investment vehicles were deemed acceptable for selection by a fiduciary.  Over time, standards and practices have changed, showing that the precise actions involved in “doing what others do” are not set in stone.

Today, being too cautious is still a potential risk for asset owners, but I would argue that most are at a greater risk of being too aggressive.  The typical pension plan or endowment is positioned much differently than in years past.  A decline in the overall rates of return available, especially on fixed income instruments, has led to increased allocations to alternative investments.State Treasurer of South Carolina | The graph in this piece illustrates the conundrum facing investors.  Risk is a multi-faceted concept, but it’s fair to say that riskier vehicles and strategies have been used increasingly over time, providing both social proofChanging Minds | The concept was introduced by Robert Cialdini. and regulatory cover for those who are uncertain how to proceed.  (Everyone is doing it.)

Recall the ERISA definition above, which includes “the circumstances then prevailing.”  Does a general decline in rates of return constitute a reason to get more aggressive in order to meet the financial plans of an organization, or should it instead lead to a reassessment of assumptions and strategies?  Which is “prudent”?

This gets to the heart of the matter.  Generally speaking, there isn’t enough discussion among fiduciaries about what constitutes prudence and what doesn’t.  A robust evaluation of investment beliefs should occur on an ongoing basis.  Those beliefs are the standards to which members of an investment committee should hold each other, and there should be regular debate about the application and continued appropriateness of them.

For example, take another statement of Grantham’s:  “As always, the prudent investor . . . should definitely recognize overvaluation, factor in regression to the mean, and calculate the long-term returns that result from this process.”GMO | This essay is called “Bubble Watch Update.”  That’s a succinct statement of GMO’s investment beliefs and, for better or worse (it’s lived through both), the firm has stuck to them over time.  Do you agree?  If not, why not?  What are your beliefs?

Or consider private equity.  Is it prudent?  Vastly more people would answer “yes” today than twenty years ago, despite an environment that has become more challenging as valuations have risen and money has flooded in.

But there is no one answer to the question.  It depends on many things, including the nature of an asset owner’s organization, its existing portfolio, its access to sufficient expertise, and its ability to realistically assess the possibilities ahead (rather than recite and depend upon the results of the past).  One giveaway that an investment in private equity wouldn’t be prudent:  if the advisors or investment committee members involved consider private equity to be less volatile than public equity.  (I’m surprised how often that is the case.)

Acting with prudence involves understanding (and admitting) what you don’t know — and discussing the inherent uncertainties involved in a strategy and its weaknesses, along with the arguments in favor.  The latter tend to dominate written reports and oral presentations, while unstated qualms and questions linger.

That increases the chances of groupthink,Psychology Today | Here is a definition of the concept and further readings. and a lack of prudence.  “An organization is only as good as its conversations,” I like to say.the research puzzle | I stole the saying from someone else, as explained here.  Prudence comes from exploration and examination, marked by that acuity and practical wisdom.

Instead, sometimes there is what might be called “prudence by rote.”  Checklists and other procedures are important components of a process, but they can lead to an implementation framework that is too rigid for the real world.  And some are just poorly designed in the first place.tjb research| That is one of the topics at the workshops I lead.

For those of us of a certain age, the phrase in this posting’s title prompts the next line of a song, “Won’t you come out and play?”Wikipedia | Here is the background regarding the song.  As with the woman named in the song, investment prudence is a concept that shouldn’t be hidden away — it should “greet the brand new day.”  Every day.  The market is a complex adaptive system, marked by worthwhile innovation as well as fashion, fancy, and folly.  A fiduciary’s job is not to do what others are doing, but to make decisions in an enlightened way.