Nobel Laureate Harry Markowitz, the father of Modern Portfolio Theory, identifies the problem all investors face: decisions about portfolio selections are made under uncertainty. This uncertainty results from the fact that there is no way to know today which investments will turn out to be superior performers and which will turn out to be inferior performers.

Many investors - including stockbrokerage firms, banks, trust companies and other investment advisors – act as if this uncertainty doesn’t exist. They believe that there is a way to know today which investments will be superior and which will be inferior. Such investors believe that the best way to “know” this is through “active investing” (stock picking and market timing), the purpose of which is to “beat the market.”

Attempts to find investment “winners” based on readings of the past or forecasts of the future do not, however, create ideal conditions for achieving investment success. In fact, those conditions are created by disciplined application of three major themes found in modern prudent fiduciary investing: broad diversification of risk, low costs and low taxes. These factors, upon which the Uniform Prudent Investor Act and the Restatement 3rd of Trusts (Prudent Investor Rule) place such great emphasis, help give investors the best chance to effectively reduce portfolio risk and enhance long term wealth.

This leads to the conclusion that actions taken to reduce risk and lower costs and taxes tend to promote prudent investing while attempts to pick stocks or time markets tend to encourage speculative investing. Apart from the fact that fiduciaries (who are responsible for managing money that is not theirs) should not engage in speculative investing, one of the many problems with speculative investing is that it requires fiduciaries to always be right.

But fiduciaries cannot always be right when it comes to portfolio performance. They can, however, be prudent when it comes to their fiduciary conduct. Fiduciaries as well as attorneys, accountants and other professional advisors who are concerned with issues of legal liability and fiduciary obligation should understand this crucial difference.

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