Modern Portfolio Theory is the Economic
Foundation for Prudent Investing

Pounding nails into steel would have been easier than trying to drive them into hundred-year-old hemlock studs. I was remodeling old Victorian homes in Toronto, and that meant replacing the lath and plaster walls with sheetrock. Back in the 1970s, we didn’t have screw guns, so we hung the sheetrock with ribbed sheetrock nails. In the battle between the sharp nail and the hard wood it was usually my arm that was the casualty. My boss, who had been doing this for years, would tap the nail into the sheetrock and then drive it home with two mighty blows. He would get a steady rhythm going like a good drummer; tap-bang-bang, tap-bang-bang, tap-bang-bang. I, on the other hand, was like Steve Martin in The Jerk⁷ with absolutely no rhythm; each tap would be followed by numerous and uneven bangs punctuated with my favorite expletive. With all this inefficient, extra motion it didn’t take long to completely exhaust myself, forcing a switch to a two-handed forehand swing for nailing walls and to a two-handed backhand motion for the ceiling. To me, restoring Victorians was more like an episode of Survivor⁸ than it was Extreme Makeover: Home Edition.⁹  

Old Victorians may be beautiful, but they aren’t too practical with their small rooms, wandering hallways, and cramped kitchens and bathrooms. To modernize them, you need to remove walls and open up spaces, which is challenging because most of the walls are load-bearing. In addition, the windows need replacing, the wiring must be upgraded, the walls have to be insulated, and the whole thing needs painting. The finished product is more open, lighter, more energy efficient, and more functional. A good remodel requires not only modern building materials and fixtures but, above all, careful planning.  

Just as building practices have changed over time, the investment practices of fiduciaries have also experienced significant change. According to the Prefatory Note, “The Uniform Prudent Investor Act undertakes to update trust investment law in recognition of the alterations that have occurred in investment practice. These changes have occurred under the influence of a large and broadly accepted body of empirical and theoretical knowledge about the behavior of capital markets, often described as Modern Portfolio Theory.”  

Modern Portfolio Theory assumes that investors are rational and risk-averse, and that markets are efficient at pricing stocks. Therefore, when making a choice among investments with the same expected return, a rational investor would choose the one with the least risk. To take on increased risk, a rational investor would need to be compensated by higher expected returns. To accept lower expected returns, a rational investor would require a corresponding reduction in risk. Since, according to the theory, concentration in a limited number of stocks is not rewarded with higher expected returns, rational investors will always diversify their portfolios. To reduce risk as much as possible, a rational investor diversifies across companies, industries, business sectors, and countries. When codifying Modern Portfolio Theory into the Act, the drafters of the Uniform Prudent Investor Act basically replaced the economic term “rational” with the legal term “prudent.”

When we were remodeling old Victorian homes, we modernized them and brought them into conformity with modern building codes. Similarly, trustees and other fiduciaries need to bring their investment and management practices into conformity with the new “building codes” of the Uniform Prudent Investor Act. Modern Portfolio Theory is the economic foundation on which these modern prudent fiduciary codes are built.