Navigating the Trustee’s Investment Duty: Understanding the Prudent Investor Rule and Diversification

When someone trusts you with their life savings, there is more at stake than simply writing checks. Trustees are fiduciaries: they must invest and manage the trust’s money prudently, not only for the present beneficiaries but often for generations to come. One of the cornerstones of modern trust law is the prudent investor rule, which tells trustees how they should think about investing. Closely related is the duty to diversify. Together, these principles guide trustees through one of the most challenging parts of trust administration—deciding what to buy, what to sell and how to balance risk and return.

Imagine a trust that holds nothing but shares of a single tech company. The stock has performed well for years and carries sentimental value for the family. When the settlor dies, the children become income beneficiaries and a sibling is named trustee. Should the trustee hold the stock out of loyalty? Or is it wiser to sell some or all of it and reinvest in a broader portfolio? These questions lie at the heart of the prudent investor rule.

What the Prudent Investor Rule Requires

In simple terms, the prudent investor rule directs a trustee to invest trust assets as if they were their own, taking into account the needs of the beneficiaries and the purposes of the trust. This does not mean a trustee must guarantee a profit or always pick winning stocks. Instead, the rule focuses on process. Trustees must gather information, consider the time horizon and risk tolerance of the beneficiaries and make investment decisions that are neither recklessly risky nor overly conservative. The Uniform Prudent Investor Act, which has been adopted in many U.S. jurisdictions, codifies these principles and shifts the emphasis from evaluating each investment in isolation to evaluating the entire portfolio.

Historically, courts measured trustees against the “prudent man rule” articulated in an 1830 case where Judge Samuel Putnam said trustees should “observe how men of prudence, discretion, and intelligence manage their own affairs.” The modern prudent investor rule builds on this idea by recognizing modern portfolio theory and risk management. A prudent trustee might invest in a mix of stocks and bonds, adjust the allocation over time and perhaps allocate a small portion to higher‑risk assets—but only if those decisions make sense given the trust’s goals.

The Duty to Diversify

One of the most concrete obligations under the prudent investor rule is the duty to diversify. Section 2(c)(5) of the Uniform Prudent Investor Act states that “a trustee shall diversify the investments of the trust unless the trustee reasonably determines that, because of special circumstances, the purposes of the trust are better served without diversifying.” Diversification reduces what investment professionals call “uncompensated” risk—the chance that a single event could wipe out the trust’s principal. The duty recognizes that even a small number of carefully selected securities in different industries can dramatically reduce risk.

Diversification happens on several levels. At the security level, a trustee should avoid letting any one holding dominate the portfolio. As a general rule of thumb, a single security that makes up more than about five percent of the portfolio should trigger a review to assess firm‑specific risk. Diversification also applies to sectors (for example, balancing technology, healthcare and consumer goods) and asset classes (mixing stocks, bonds, real estate and cash). By spreading investments across these categories, trustees ensure that a downturn in one area will not devastate the entire trust.

When Concentration Might Be Permitted

Despite the general mandate to diversify, there are times when it may be prudent—or even required—to hold a concentrated position. Many family trusts are funded with a closely held business, a farm or a significant holding in one publicly traded company. If the settlor’s primary goal is to keep the business intact for future generations, then diversification might not serve the trust’s purpose. In such cases, the trustee should look carefully at the trust document. Some trusts expressly authorize holding a particular asset, while others waive the duty to diversify. When the terms are silent, trustees can sometimes petition a court for instructions or seek consent from all beneficiaries. Even then, trustees must monitor concentrated positions and periodically reevaluate whether special circumstances continue to justify the risk.

How Trustees Fulfill Their Investment Duties

The prudent investor rule does not expect trustees to become professional money managers overnight. Instead, it expects them to act like prudent investors: to educate themselves, to seek expert advice where necessary and to make deliberate decisions. In practice, a trustee might begin by creating an investment policy statement that outlines the trust’s goals, time horizon, risk tolerance and asset allocation strategy. This document serves as a roadmap and a record of the trustee’s reasoning. The trustee should then implement the strategy—perhaps by hiring a professional investment adviser—and revisit it regularly, adjusting as market conditions and beneficiary needs evolve.

Documentation is critical. If a trustee decides to hold a concentrated stock position, they should record why the decision was made and what alternatives were considered. If they decide to sell and diversify, they should record how the proceeds will be reinvested. Courts and beneficiaries judge a trustee’s actions by the process they followed; a well‑documented process is the best defense against claims of imprudent investing.

Practical Examples

Consider a trust that owns $2 million worth of stock in a single pharmaceutical company. After the settlor’s death, the trustee reviews the portfolio. The beneficiaries are middle‑aged siblings who depend on the trust for supplemental income. The trustee consults with a financial advisor and learns that although the company’s prospects are promising, its stock has historically been volatile. Following the prudent investor rule, the trustee decides to sell half of the stock, invest the proceeds in a diversified mix of index funds and bonds and retain the remaining shares to preserve some upside. The trustee documents the rationale—reducing uncompensated risk while respecting the family’s attachment to the company. Over the next year, the market wobbles, but the diversified portfolio provides steady income, and the remaining shares appreciate. Because the trustee made a reasoned, balanced decision, they can demonstrate compliance with their duties.

In another situation, a trust consists largely of a family farm that has been in the family for generations. The settlor’s intent, expressed in the trust instrument, is to keep the farm intact for the next generation. Although diversification would normally require selling a portion and reinvesting elsewhere, the trust document waives that duty. The trustee continues to manage the farm, perhaps leasing it to a tenant farmer to generate income, and monitors its economic viability. Here, the trustee’s adherence to the settlor’s intent and the terms of the trust satisfies the prudent investor rule despite the concentrated asset.

Why It Matters

At first glance, investment duties may seem like an abstract legal concept, but they have real consequences. A trustee who fails to diversify could see the trust wiped out by a single corporate scandal or market crash. A trustee who invests too conservatively may fail to keep up with inflation, eroding the trust’s value over time. And a trustee who cannot explain their investment decisions may face litigation from unhappy beneficiaries. Following the prudent investor rule and the duty to diversify protects trustees and beneficiaries alike by promoting thoughtful, balanced decision‑making.

Final Thoughts

Serving as a trustee is not just about distributing assets; it is about stewarding wealth through time. The prudent investor rule gives trustees a framework for how to think about investing, while the duty to diversify guards against catastrophic loss. By understanding these duties, creating an investment strategy, seeking professional help when needed and keeping detailed records, trustees can honor the settlor’s intentions, provide for beneficiaries and protect themselves from liability. In the end, prudent investing is less about predicting markets and more about making informed, disciplined decisions—exactly what the law expects of a trustee.