The "Prudent Family" Rule in Portfolio Management

In portfolio management, there is a rule known as the "Prudent Man" rule. This rule dictates that an investment professional who is entrusted to invest a trust fund on his clients' behalf has to act as what a prudent man would have done if there were no specific investment instructions. This post is not about the "Prudent Man" rule, but is a light-hearted post introducing a new "Prudent" rule, which is the "Prudent Family" rule. Note that although the Prudent Family also has a Prudent Man as a family member, he is not the same man as in the "Prudent Man" rule. For the rest of this post, "Prudent Man" refers to the Prudent Man in the Prudent Family, not the Prudent Man in the "Prudent Man" rule. 

The "Prudent Family" rule provides a light-hearted way of looking at portfolio allocation among various asset classes. By following the "Prudent Family" rule, you will find that you will end up with a balanced portfolio of stocks, bonds, hybrid securities/ alternative investment and cash. The largest proportion will be stocks, followed by bonds, hybrids/ alternatives and cash. Let me now introduce the various members of the Prudent Family.

Firstly, who in the Prudent Family would find it prudent to hold stocks, which offer high growth but are  more volatile? Needlessly to say, it would be the Prudent Man, who will want to have some adrenaline and capital appreciation in the Prudent Family Portfolio. Also, being the head of the household, he will have the largest say in the portfolio. Following stocks in the Prudent Family Portfolio will be bonds, which are almost the direct opposite of stocks with lower growth but higher stability. So, who in the Prudent Family would think it prudent to hold an opposing view from that of the Prudent Man? That would be the Prudent Woman. As the saying goes, behind every successful man is a woman. Being the woman behind the Prudent Man, she will have the second largest say in the family portfolio.

Next on the Prudent Family Portfolio are hybrids/ alternatives. Hybrid securities, as the name suggest, have characteristics similar to both stocks and bonds. Examples would be convertible bonds, which pay regular coupons (i.e. dividends) like normal bonds but can rise and fall in value with a corresponding rise or fall in the mother shares. Even REITs can be considered to fall into this category. Alternative investments, on the other hand, bear little or no relationship to the traditional asset classes of stocks and bonds. Examples would be commodities, which do not pay regular dividends and are most of the time not correlated to the price movement of traditional asset classes. Coming back to our Prudent Family, who would think it prudent to have characteristics of both the Prudent Man and the Prudent Woman or be totally independent of them (i.e. do not take any sides)? That would be the Prudent Child. Being the youngest member in the family, the Prudent Child has a small say in the family portfolio, especially if he prefers full independence from the Prudent Man and Prudent Woman.

Finally, the last on the Prudent Family Portfolio is cash. As we all know, cash earns very little in interest and is easily eroded by inflation. Given such characteristics, who in the right mind in the Prudent Family would think it prudent to hold cash? That must be the Prudent Mistress, isn't it?

So, in the Prudent Family, the Prudent Man would hold stocks for growth, the Prudent Woman would hedge against the Prudent Man with bonds, the Prudent Child would either hold hybrids or alternatives so as not to take sides with either the Prudent Man or the Prudent Woman, and the Prudent Mistress would embrace cash for safety.

It is worth highlighting that for the Prudent Family Portfolio to work well, every member of the Prudent Family has to be prudent. For example, if the Prudent Mistress becomes imprudent and holds too little cash, the entire portfolio will be subject to the depressions of Mr Market which the Prudent Family cannot fight back against. Conversely, if the Prudent Mistress becomes too prudent and holds too much cash (which means that the rest of the Prudent Family become imprudent), the portfolio will be eroded by inflation. You can work out the outcomes on the portfolio if the other members of the Prudent Family become imprudent. In all cases, the outcomes will be negative. Hence, every member of the Prudent Family has to play his/her respective role well to ensure that the Prudent Family Portfolio can achieve its investment objectives.

If you find the Prudent Family is an interesting family, there's still one more person in the Prudent Family for you to meet. That would be its originator, (The) Boring Investor :)