Uncompensated Risk: Law Excerpts from Restatement Volume 8, 1992
Administration of Trust Prudent Investor Rule, Section 227, Chapter 7
Excerpt 1: Risk management
In understanding a trustee’s duties with respect to the management of risk, it is useful to distinguish between diversifiable (or “uncompensated”) risk and market (or non-diversifiable) risk that is, in effect, compensated through pricing in the marketplace. The distinction is useful in considering fiduciary responsibilities both in setting risk-level objectives and in diversification of the trust portfolio.
In the absence of contrary statute or trust provision, the requirement of caution ordinarily imposes a duty to use reasonable care and skill in an effort to minimize or at least reduce diversifiable risks. Often called non-market risk, or somewhat less precisely “specific” or “unique” risk, these are risks that can be reduced through proper diversification of a portfolio. Because market pricing cannot be expected to recognize and reward a particular investor’s failure to diversify, a trustee’s acceptance of this type of risk cannot, without more, be justified on grounds of enhancing expected return. What has come to be called “modern portfolio theory” offers an instructive conceptual framework for under- standing and attempting to cope with non-market risk. The trustee’s normal duty to diversify in a reasonable manner, however, is not derived from or legally defined by the principles of any particular theory. See Reporter’s General Note on Comments e through k for discussions of asset pricing, types of risk, and the advantages of diversification.
Another aspect of risk management deals with market risk, often called “systemic” or “systematic” risk, or more descriptively for present purposes, simply non-diversifiable or compensated risk. The trustee’s duties and objectives with respect to this second category of risk are not as distinct as those with respect to diversifiable risk. They involve quite subjective judgments that are essentially unavoidable in the process of asset management, addressing the appropriate degree of risk to be undertaken in pursuit of a higher or lower level of expected return from the trust portfolio. In this respect the trustee must take account of the element of conservatism that is ordinarily implicit in the prudent investor rule’s duty of caution. Opportunities for gain, however, normally bear a direct relationship to the degree of compensated risk. Thus, although an inferred, general duty to invest conservatively is a traditional and accepted feature of trust law, that duty is necessarily imprecise in its requirements and is applied with considerable flexibility. (Despite the flexibility of the trustee’s in this respect, it is often possible to obtain useful and, in a sense, objective information about degrees of risk associated with a stock or bond or with a portfolio of securities. See Reporter’s Notes.
For purposes of understanding and applying the fiduciary duty of prudent investing, it is essential to recognize that compensated risk is not inherently bad. Therefore, no objective, general legal standard can be set for a degree of risk that is or is not prudent under the rule of this Section. Beneficiaries can be disserved by undue conservatism as well as by excessive risk-taking. Decisions concerning a prudent or suitable level of market risk for a particular trust can be reached only after thoughtful consideration of its purposes and all of the relevant trust and beneficiary circumstances. This process includes, for example, balancing the trust’s return requirements with its tolerance for volatility.
Excerpt 2: Diversification
Despite variations and flexibility in all of these matters, one pervasive generalization prevails concerning the prudent investor’s duty of caution: reasonably sound diversification is fundamental to the management of risk, regardless of the level of conservatism or risk appropriate to the trust in question. Therefore trustees ordinarily have a duty to diversify investments. See Comment g, below. The purpose of diversification (apart from the role it may play in discharging the trustee’s duty of impartiality) is not only to moderate risks that are inherent in investing but also to reduce risks that are not justified by some prospect of gain.
Excerpt 3: Diversification
Failure to diversify on a reasonable basis in order to reduce uncompensated risk is ordinarily a violation of both the duty of caution and the duties of care and skill. See Reporter’s Notes; also see Comment m, below, on the use of mutual funds and other pooled investment arrangements for this purpose. On the other hand, the prudent investor rule is considerably more flexible in addressing questions concerning the degree of compensated risk, essentially questions of conservatism. This flexibility is appropriate because of the tradeoff between risk and expected return, and because a consideration of the purposes, obligations, and circumstances of the trust is proper in evaluating the suitability of a trustee’s investment strategy. Nevertheless, the facts of Illustration 12 suggest no justification for the described degree of commitment to a high-risk-and-reward strategy. · The reason, however, is not that the investment of trust funds in relatively unestablished enterprises is impermissible if done in a prudent manner in appropriate trust situations. See Comment p, below, and, more generally, Reporter’s Notes.
Excerpt 4: Risk and the requirement of diversification
As a result of the tendency of the value fluctuations of different assets to offset one another, a portfolio’s risk is less than the weighted average of the risk of its individual holdings. A portfolio’s expected return, on the other hand, is simply a weighted average of the expected returns of the individual assets. Thus, the expected return is not affected by the portfolio’s reduced level of what is often called “specific” or “unique” risk-insofar as those terms are used to refer to risks that can be reduced by diversification. Other types of risk, however, are generally compensated through market pricing, so that the expected return from an investment or portfolio is directly affected by the level of these risks that cannot be diversified away-the so-called “market” or “systematic” risks. Accordingly, a trustee’s duty of prudent investing normally calls for reasonable efforts to reduce diversifiable risks, while no such generalization can be made with respect to market risk. See discussion of risk management in Comment e, above, dealing with the duty of caution.
Significant diversification advantages can be achieved with a small number of well-selected securities representing different industries. and having other differences in their qualities. Broader diversification, however, is usually to be preferred in trust investing. Broadened diversification may lead to additional transaction costs, at least initially, but the constraining effect of these costs can generally be dealt with quite effectively through pooled investing. See Comment m, below. Hence, thorough diversification is practical for nearly all trustees. The ultimate goal of diversification would be to achieve a portfolio with only the rewarded or “market” element of risk.
The rationale of the trust law’s requirement of diversification is more than conservatism or a duty of caution, which admonishes trustees not to take excessive risks-that is, not to take risks higher than suitable to a trust’s purposes, return requirements, and other circumstances. The general duty to diversify further ex- presses a warning to trustees, predicated on the duty to exercise care and skill, against taking bad risks – ones in which there is unwarranted danger of loss, or volatility that is not compensated by commensurate opportunities for gain. Thus, while risk-taking cannot realistically be forbidden, or subjected to an arbitrary ceiling, it is required to be done prudently. A central feature of such prudence ordinarily is the reduction of uncompensated risk through diversification.
This generalization does not apply to non-diversifiable, compensated risk. In constructing a portfolio, the degree of such risk in a trust’s investment program is properly a matter of conscious decisions to be made by the trustee, influencing, for example, the ratings of bonds to be held in a portfolio of debt securities and the risk level of a stock portfolio. The trustee has an obligation to make this strategic decision after careful consideration of the risk-reward tradeoffs involved and after considering the potential cash-need consequences of the risk element in that choice. This decision making is to be done with the general and flexible fiduciary duty of caution in mind.
Excerpt 5: Duty with respect to delegation
With professional advice as needed, the trustee personally must define the trust’s investment objectives. The trustee must also make the decisions that establish the trust’s investment strategies and programs, at least to the extent of approving plans developed by agents or advisers. Beyond these generalizations, expressed in terms that are necessarily imprecise, there is no invariant formula concerning functions that are to be performed by the trustee personally.
Excerpt 6: Risk and the duty to diversify
Because all economic events do not affect the value of all investments in the same way, risk (or volatility, which is often referred to in economic literature as “standard deviation,” which in turn is the square root of variance) is always greater with a single stock than it is with multiple stocks. At least this is true unless their returns are perfectly correlated-that is, unless they vary identically, as one could only hypothesize. To the extent their outcomes are opposed, so that variations in result would tend to cancel each other, the portfolio receives the benefit of reduced risk (that is, a reduction in the firm specific or diversifiable element of risk) with no impairment of the portfolio’s average return expectation.
Effective diversification, then, depends not only on the number of investments but also on the ways and degrees in which their responses to economic events tend to cancel or neutralize one another through negative or slight “covariance.”
As a result, a portfolio’s risk is less than the weighted average of the risk of its individual holdings. A portfolio’s expected return, on the other hand, is simply a weighted average of the expected returns of the individual assets. Thus, although the portfolio’s expected return is affected by changes in its level of market risk, expected return is not affected by changes in the portfolio’s level of specific risk (or “unique” risk, as this diversifiable risk is often called). Accordingly, minimization of the latter becomes a significant goal of prudent investing, while no such generalization can be made with respect to the former.