In case you haven’t noticed, after a relatively “quiet” first half of 2019, volatility has returned to the financial markets in a big way. The stock market was down about 3 percent just the other day.
As I understand it, uneasiness about a trade war with China, a global economic slowdown, and increasing tensions with Iran and North Korea, are the main culprits. But then, who knows? The markets sometimes dramatically move for no apparent reason.
Over the last five years, except for 2017, the markets have been moving around a lot. I remember earlier this year when a friend nearing retirement told me how shocked he was when he opened his retirement account statement for the last quarter of 2018 and saw that it had “lost” almost 10% of its value.
But by the middle of this year, he had made everything back, and then some. Stocks rebounded sharply after the “Christmas Eve massacre” of 2018—the S&P 500 gained about 17% in the first quarter of 2019. That was its best first half-year performance since 1997. But since June, the markets have been rockin’ and rollin’ again.
Those nearing or in retirement are understandably concerned about how the markets perform. All the more if most of their investments are in the stock market. Risk of loss just before or in the early years of retirement (what is known as “sequence of returns risk”) is real, but volatility alone doesn’t cause that.
Sequence risk is the advent of a long-duration down-market that may difficult to recover from. To illustrate: if you have $100,000 invested and lose 30% over three years, you will have to earn back about 43% to get back to even. The math is: [$100,000 – ($100,000 x .30) = $70,000]; and, $30,000 /$70,000 = .4285. It would take at least seven years to get back to $100,000 if the market grew at 6% a year each year after that, which isn’t likely. And remember—if you’re in retirement, you are probably withdrawing 3 to 5 percent a year as income to boot, and that can cause it to take even longer.
So, losses matter—not as much as other things, but because large, permanent losses can impact our long-term financial health. Therefore, it is wise to try to minimize them as best we can.
How much you lose in a prolonged down market will have a lot to do with how diversified you are. If you have a very high percentage of your retirement investments in stock, sequence risk can have devastating effects. But if you have less (say, 40%), then your total losses would be reduced—30% of 40% is 12%.
The “prudent man rule”
In light of all this uncertainty, what is a wise steward to do? Well, I want to introduce you to something called the “Prudent Man Rule.” It sounds like something right out of the Bible, but it isn’t. As we shall see, it does align with some biblical principles.
The “prudent man rule” actually came out of an 1830 court case (really reaching back here) that involved what was then called Harvard College. The college was set to receive an endowment in the full value of a trust fund of approximately $50,000 (which equates to over $1 Mil. in today’s dollars) after the last beneficiary of the trust passed away.
At issue was the fact that the trustees had 100% of the trust’s funds invested in stocks with no allocation whatsoever to fixed income instruments of any kind. When the beneficiary passed, the fund was worth almost 50% less ($29,000). Harvard then filed suit against the trustees, claiming that the trustees had jeopardized the trust by investing it too aggressively.
The court ultimately found for the defendants (the trustees). It also found that they had acted as any prudent person would in a similar situation, considering their skills and the economics of the time.
This ruling established a legal precedent giving trustees broad discretion in the construction and management of investment portfolios. But in 1869, another case in New York significantly reduced the list of “acceptable investments” that would be allowed based on the prudent man rule. The only investments that were deemed to be “acceptable” were government bonds (a.k.a., “treasuries”), and notes with real estate as collateral (i.e., mortgage-backed securities).
Since then, there have been adjustments to the rule to allow for great sophistication in response to modern financial instruments and portfolio management strategies. (Keep in mind—there were no mutual funds or ETFs back in 1869).
Specifically, these adjustments allowed portfolio managers to look at their investments in the whole—as an entire diversified portfolio with a total return index as a benchmark. This change expanded the types of securities that can be included and gave the manager more latitude in constructing a “suitable” portfolio for the client.
So, while the prudent man rule still exists as an investment standard, it allows for a broader range of investment options.
The original rule described the prudent man rule as follows:
To observe how men of prudence, discretion, and intelligence manage their own affairs, not in regard to speculation, but in regard to the permanent disposition of their funds, considering the probable income, as well as the probable safety of the capital to be invested.
In plain English, this means that a “prudent” person who has discretionary control over the assets of another (or, we could say, as pertaining to the management of their assets) should only invest in holdings with risks that a person of reasonable intelligence would consider wise and with a low probability of permanent loss.
Translated even more loosely, it means “don’t do dumb things with other people’s money,” but we could personalize it to say, “don’t do dumb things with your own money.”
The rule does not suggest that it is prudent not to take any risk at all. However, it does suggest that taking unnecessary risk with a high probability of total loss, would be extremely imprudent; i.e., “dumb.”
The Bible’s “prudent man rule”
In reality, there is no prudent man “rule” in the Bible—it doesn’t talk about prudence in investing specifically, certainly not in modern terms. But the Bible does teach prudence, and I think a good definition of it can be found in Webster’s Dictionary (1828):
Wisdom applied to practice…but that it differs from wisdom in this, that prudence implies more caution than wisdom, or is exercised more in foreseeing and avoiding evil, than in devising and executing that which is good. It is sometimes mere caution or circumspection.
Based on this definition, we might say that the Bible teaches that a prudent person is careful and wise in how they handle practical matters in their life (such as investing), exercising sound judgment and common sense in doing so. They perceive the risks and dangers involved, and protect themselves as best they can while seeking God’s guidance and care all along the way.
If you ask other Christians about this, you may find they are in different camps. But these “camps” may be based more on personal opinion than biblical principles. Some would say that owning stocks or stock fund is prudent. Others might say that owning no stocks is and investing only in treasury bonds is prudent. An insurance guy might say that the only prudent thing for a retiree to do is to purchase an annuity. Others would suggest it could be imprudent to hand over a big chunk of money to an insurance company. (I could go on.)
Although the Bible isn’t that specific about such things, it does have some things to say about “the prudent person” that can be used in the context of stewardship in general, and investing in particular:
1. The prudent person has foresight. They live in the present but plan for the future, recognizing the inherent uncertainty. (See: Pr.2:11; Pr.6:6-8; Pr.22:3; Pr.27:23; Ec.7:14; Js.4:13-15.)
Foresight is not foretelling—none of us can tell the future. Therefore, we don’t know precisely how long we will live on this earth. Foresight means that the prudent person considers the future; they look ahead and realize that there is the possibility of a long life, and thus the need to fund a possibly long time in retirement. Accordingly, they do not postpone saving for retirement; they start as soon as possible.
If we limit our saving and investing time horizon to the last 10 or 20 years of our working life, we may dramatically reduce the probability of meeting our retirement savings goals. Starting to save as early as possible puts the “power” of compound interest to work and increases our chances of success.
The prudent person saves enough. Those in their 20s and 30s save between 12% and 18% of their salary but have to ramp up to 25% to 50% if they wait until age 40 or 45. If they are not able to do this, they will have to downsize their lifestyles to enable them to live off their retirement savings.
The prudent person estimates what their future needs might be. Consequently, if they start early and save consistently, they will also know when they have saved enough—they have reached their “savings finish line,” so to speak. The prudent can then redirect any surplus to other productive purposes (such as giving).
2. The prudent person exercises caution. They recognize the opportunities and benefits of investing but also understand the dangers and risks. (See: Pr.22:3; Pr.23:1-3; As.5:13.)
The risks of investing are ever-evident. My earlier discussion about 2018 and recent market volatility reinforces that fact.
Some prudent risk-taking and profit-sharing through economic transactions is commended in scripture if done wisely (Pr.31:10-31; Ecc.11:1-6). But we must always remember that profit from such activities is never guaranteed.
Furthermore, the principle of risk and reward is always in effect—higher risk offers the possibility of greater reward along with a higher probability of loss. Therefore, the prudent investor would not “risk all” for the sake of a bigger reward.
Understanding and acting in line with their risk tolerance is a characteristic of the prudent investor. They know that certain assets (such as stocks) are more volatile than others; that they can increase or decline dramatically. But they also know that such assets have characteristically increased over the long term. They also know whether they can “stomach” the decreases while not over-enjoying the increases. If not, they adjust their allocations to risk-based assets accordingly.
Knowing their risk tolerance and developing an investment strategy that is consistent with it enables them to “stay the course” in spite of market volatility.
3. The prudent person seeks knowledge and then wisely applies it to their situation. (See: Pr.12:23; Pr.14:18; Mt.7:6; 2Ti.2:15.)
The acquisition of knowledge begins with studying scripture and the wisdom it teaches about money. The prudent person manages their money based on solid biblical principles, and wise practices learned from others.
Prudent people accept that investing and the financial markets are complex and can, therefore, be challenging to understand. Although a prudent person can learn much about them, few will ever become “experts.” Thus, they do not overestimate their insight or knowledge and will need to seek out the assistance of others.
Such assistance can come in many forms—books, articles, blogs, classes, and of course, direct personal investment advice or portfolio management services. But to benefit from them, the prudent person must be teachable; they must be willing to consider new ideas and perspectives. They may need to set aside their own biases and opinions and be willing to try different things.
4. The prudent person acts rationally when making investment decisions. (See: Pr.13:16; Pr.15:2; Ec.10:3.)
The prudent don’t act impulsively when investing; they learn to control their emotions and make decisions based on wisdom and knowledge gained through experience, exercising discipline and restraint when others aren’t. During times of market upheaval, we often act irrationally and lose sight of our long-term financial goals. Overreacting to short-term market events is almost sure to cause loss—permanent loss.
We tend to experience short-term “paper” losses as an immediate threat to our long-term savings. In trying to alleviate the danger, we do the very thing we are trying to prevent—we realize the loss by selling assets when they are down.
The prudent person understands that, if they have a good investment plan that they are comfortable with, they can stay calm and rational and stick to it.
5. The prudent person will practice biblical discernment in all areas of life, including money management and investing. (See: Pr.14:15; Pr.12:16; Pr.14:8; Lk.14:28-32.)
The discerning person can tell the difference between right and wrong, good and evil, and between what is true and what is false, based on biblical truths. They think biblically about all areas of life, which includes money and investing.
Investing decisions are not always so black and white. Nonetheless, a prudent person will be thoughtful in making investment decisions. They will be able to distinguish between good, better, and best for their particular situation.
Prudent persons do not act naïvely or foolishly. For example, they would not purchase a particular investment or a sophisticated financial product, such as an annuity, without doing their homework and asking lots of questions to make sure they fully understand what they are buying and why.
They would quickly recognize a “too good to be true” investment and turn away from it. The prudent will know a “get rich quick” scheme when they see it. They are sometimes skeptical, but not necessarily cynical. And even when they get advice from a “trusted authority,” they treat it with a grain of salt.
They will deal wisely with others who are involved in their financial affairs, recognizing that conflicts of interest may be present.
6. The prudent person will diligently manage their investments, individually or with the help of a trusted advisor. (Pr.6:6-11; also, Gn.41:33-40; Pr.24:27; Mt.25:14-30.)
Through diligence, the prudent will grow their money using the power of compound interest, at least enough to stay ahead of inflation. Therefore, the prudent person will manage their resources well by investing in something other than cash. (Although keeping some percentage in cash can also be prudent.) Stuffing your money in the mattress means it is going to lose money each year (it will buy less due to inflation).
But, interestingly, many investors can be too risk-averse; they can be too conservative and don’t invest in assets that can sufficiently beat inflation. That is not necessarily prudent either.
I understand why someone would want to set the probability of losing their investment capital to near zero, but they may not realize that those types of investments rarely keep up with inflation. We don’t want to unwise and take too much risk, which amounts to over-speculation and gambling on future events, sometimes with borrowed money (for example, margin accounts and hedge funds).
What should the prudent man do? Diversify, diversify, diversify! A single company’s stock or bonds can tank at any time. If you expand your investments across lots of companies, either by investing in lots of individual shares or mutual funds, you may lose on some of the different companies, but probably not all of them.
Also, if you “balance” your portfolio by holding both stocks and bonds, you can reduce your risk even further. The performance of these asset classes tends to be uncorrelated in specific economic scenarios, but there are times when both can move in a negative direction.
Another benefit of a balanced portfolio is that it can tamp down both fear (when things are going really bad), and greed (when they are doing particularly well).
7. The prudent person is humble. (See: Pr.11:2; Pr.12:15; Pr.15:5; Pr.15:32; Pr.16:16; Pr.26:12.)
Humility in this context means acknowledging that all that we have has been given to us by God for our good and his glory. Therefore, we should not think too highly of our abilities, intellect, accomplishments, or any money we have managed to save and invest, or how well our investments have performed.
The prudent person acknowledges their limitations, shortcomings, and mistakes, accepts uncertainty and ambiguity, does not presume on the future, and seeks out the knowledge and wisdom of the Scriptures and the wise counsel of others when necessary. The challenge, of course, is that we are at times more prone to over-confidence and arrogance than humility. If we don’t humble ourselves, the vicissitudes of life eventually will—and reality can be a harsh schoolmaster.
Successful investors are particularly vulnerable to what is called “overconfidence bias,” which is assuming that just because something has worked well in the past that it will work just as well (or better) in the future. Prudent investors won’t be overly surprised when things do not turn out well—they have realistic expectations.
Be a prudent person (and investor)
You don’t have to sport a well-groomed handlebar mustache and a sherlock-holmes-style pipe to be a prudent man. You just need to understand and apply some relatively simple principles. Doing so won’t make volatility and market risk go away, but it will make it easier for you to deal with. Prudence gets you the whole package:
I, wisdom, dwell with prudence, and I find knowledge and discretion. Proverbs 8:12 (ESV)