Prudent investor must act as other prudent investors who manage similar portfolios, with similar investment objectives, act. Professional money managers can exercise judgment when taking care of other people's money -- but they cannot take any action that is too risky -- they cannot speculate by buying options, nor can they trade penny stocks, etc.
The definition of a prudent investor has undergone major changes over the years and the prudent investor rule describes the standards to which managers must adhere when investing client money.
One hundred years ago, no manager would consider investing in the stock market. Before 1945, prudent investment professionals, and the law governing their liabilities, condemned stock investing as imprudent speculation.
Later (after WW2), as inflation became part of our lives and the legal view of stock investing changed, stocks became the core holding of most investment portfolios.
In modern times, as it became clear that few investment professionals could outperform the stock market (as measured by the performance of broad-based indexes, such as the S&P 500), the law came to accept passive investing (indexing) as a prudent strategy. Advisors may now own index funds and are not required to search for outstanding investment opportunities.
This simplified road to investing became the norm. Prudent money managers were pleased when they matched the returns of their peers. Imprudent managers remain in business. They seek higher returns by taking extra risk because they want to achieve results that attract new investors.
As the market soared during the 1980's and 1990's those 'average' returns were more than acceptable to most investors as the value of their portfolios grew. When the bubble burst, and the markets declined, average returns turned negative. That’s when people noticed that hedge funds were outperforming the overall market.
Although these funds keep their trading strategies secret, it is known that they take advantage of derivatives (including options) to find investment opportunities that are not available to traditional money managers.
Some of these superior returns are due to the use of leverage, i.e., borrowing money (use margin) to increase the size of an investment portfolio. In addition, a significant part of their profitability comes from the use of derivative products, including options.
Although many investors get greedy when markets rise, savvy investors are always aware that the stock market may reach a top, with a decline on the horizon. The appeal of hedge funds and their ability to adopt risk-reducing option strategies, such as those described in the Rookies Guide to Options, is attractive to a greater number of prudent investors. That includes professional managers as well as individual investors.
As hedging strategies become more and more accepted, will they become the new standard for the prudent investor? Is it possible that the versatile stock option can become the investment tool of choice for risk adverse investors? Only time will tell, but I believe that’s the direction in which we are headed. It’s reasonable to anticipate that option usage will eventually be widely accepted as an acceptable investment tool for the prudent investor. But of course, you already know that options are perfect tools for prudent investors.