Risk and Return

The Prudent Investor Standard asserts that managing the inherent trade-off between risk and return is the central consideration for fiduciaries. What exactly does this mean?

In finance and investing, it is an accepted truth that in order to earn higher returns, one must be willing to accept higher levels of risk. Since risk takes many forms (examples: credit risk, interest rate risk, liquidity risk, market risk, etc.), this trade-off arises in a variety of situations. The key consideration is relative value. Given two different investment choices, a fiduciary is required to pick the one offering the greater value relative to the claimant’s situation. This choice can be illustrated with a simple chart:

Consider the following questions: 

1. Given the choice between investments A or B, which must a fiduciary choose and why?

Answer: B, because it represents higher return at no greater risk.

 

2. Given the choice between B and C, which must a fiduciary choose and why?

Answer: B, because it represents equal return at lower risk.

 

3. Given the choice between C and D, which must the fiduciary choose?

Answer: judgment call. D represents higher risk but also potentially higher return. All else being equal, added risk is permissible so long as the fiduciary determines that the increased risk is fairly offset by a potentially higher return.

 

Most of the financial decisions you will make on behalf of an injured person can be plotted on a grid like this, and they probably should be. Relative value is the central consideration of fiduciary investing; charts like this will simplify your decision-making.

[return to top]