5 Essential Rules of Prudent Investing

Posted on May 13, 2014 at 3:05 PM PST by

If you engage a financial planner in a conversation about investing, it’s likely that you will hear him or her talk about the “prudent-man rule.”

Sometimes called the “prudent-person” rule, the idea is simple: Don’t do dumb stuff with your client’s money.

What’s dumb? That’s open to interpretation, of course. You can easily find people online who will make the case that owning stocks at all is imprudent, or that owning anything other than precious metals and real estate is imprudent.

prudent investing

Likewise, I am sure an insurance agent could quite cogently make the case that only an annuity is prudent, despite the high fees involved.

Even the definition is reflexive. The prudent-man rule simply states that a money manager should invest in assets that a prudent person seeking appreciation and income would expect to see in his or her portfolio.

That just throws it back on the client, who presumably hired the money manager because he or she didn’t feel qualified to find prudent investments alone.

To clear things up, here are five essential rules of prudent investing:

1. Own mostly stocks and bonds

The narrower the investment type, the more likely you are to experience gut-wrenching volatility. It’s very easy to get scared out of an investment that moves unexpectedly higher or lower in short periods of time.

Major-index stocks and widely held bonds move in a more predictable fashion. You can own small caps and foreign equities and foreign bonds if you want, but keep those concentrations low relative to the main U.S. stock and bond core of your portfolio.

2. Own small slices of alternatives

Yes, you should own commodities (a little), real estate (perhaps a little more) and even emerging markets stocks. But keep things realistic. While non-traditional asset classes can offer you higher highs, they also deliver lower lows. Use them to dampen overall volatility, not as a way to make up lost ground in a general market rout.

3. Rebalance periodically

Banking your gains is a huge tactical advantage that too many investors ignore. If stocks rise so high that your portfolio percentages get out of whack, sell off the excess returns and purchase things that have fallen out of favor.

Reversion to the mean will reward you by bringing the lower stocks higher, while cashing out on time means you get some gains before the winners fall back to earth.

4. Keep taxes minimized

Who likes paying taxes? Nobody. Investing through an IRA will allow you to reinvest gains tax-deferred. If you must use a taxable account, remember that stocks held for a year are taxed at a lower rate than short-term trades. Index funds and index ETFs can help you own stocks while avoiding the worst of the tax bite.

5. Keep fees minimized

This is last on the list but by far the most impactful. Even fees that seem small can add up to a large chunk of your potential investment return. Using a simple portfolio of index ETFs can dramatically reduce your cost and increase your total retirement gain.