INVESTING TERMS
What is the
PRUDENT
The prudent investor rule is a legal guideline for trustees of investment portfolios. It requires a fiduciary to act in the best interest of
the trust’s beneficiaries and
outlines standards for legally
controlling investment
portfolios. The prudent investor
rule is very influential in the
courts, the U.S. government
and the banking industry.
Deeper definition
At the most basic level, there are two kinds of stock: preferred and common. Preferred stock is rarer than common stock, generally comprising a small proportion of all shares. It’s often more expensive, and can come with a minimum purchase amount.
Prudent investor rule example
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INVESTOR RULE?
No one can perfectly
predict the outcome of
every investment
decision, but a trustee
must apply the prudent
investor rule when
making investment decisions
based on the information available
at the time. Whether the outcome is good or bad is not a factor if the trustee followed the principles of the prudent investor rule.
SHORT-TERM
CAPITAL GAINS
Profits made from selling assets owned for one year or less.
LONG-TERM
CAPITAL GAINS
Profits made from selling assets owned for more than one year.
Jeff bought a vacation home for $100,000 and used it as a rental property for five years before selling it for $150,000, giving him a capital gain of $50,000.
Since he owned the property for more than one year, he calculated his long-term capital gain based on his tax bracket.
Since his annual income placed him in the 15 percent tax bracket ($37,651 to $91,150 for a single person in 2016), he didn’t have to pay any taxes on the profit.
If Susan pays only the minimum payment of $20 per month, it will take her 11 months to pay off her balance.
EBITDA doesn’t need to be measured by the Securities and Exchange Commission’s accounting standards, the Generally Accepted Accounting Principles (GAAP), so it is not a required line item on a company’s financial statement. EBITDA has become much more common in recent years, although many firms list an adjusted EBITDA figure.
Richard is an elderly investor who has entrusted his capital to an investment manager who helps him identify the best investment
opportunities. The trustee is
obliged to follow the
prudent investor rule and
make sound decisions
based on the goals,
requirements and risk
tolerance of Richard, his
client. For example, the
trustee will not invest Richard’s money in the lottery or penny stocks, which are known to be risky. Instead, the trustee has to invest Richard’s money as if it were his own and follow the guidelines of the prudent investor rule, even if the results fall short of investment goals.
Before the proliferation of
inexpensive computer
technology, it had been very
difficult to create and price
complicated derivative contracts, but this problem was more or less solved by the 1990s, thanks also to the Black-Scholes equation. Mortgage-backed securities became very common investment products. Instead of using derivatives to effectively balance risk, institutional traders began buying them up as ways to create leverage and take on much more risk. When the U.S. housing market began to crumble in 2006 and 2007, MBS investments spread throughout the banking system began to rapidly lose value, precipitating the crisis.
MARKET CAP
VALUE
OUTSTANDING SHARES
SHARE PRICE
OF THE STOCK
When a company issues more shares, the price of an individual share falls. Anti-dilutive preferred stock allows investors to receive more shares of a stock than he original paid for in the event that his are worth less as a result of a dilution.
The measure can be calculated by taking a company’s net income and adding back interest expense, taxes, depreciation, and amortization. Alternatively, it can be calculated by taking a company’s operating profit — EBIT, or earnings before interest and taxes — and adding depreciation and amortization.
Susan opens a credit card with a $1,000 credit limit and an interest rate of 14.99.
She makes a purchase of $200.
Susan understands she will pay interest on the balance until she pays it off, but she decides to carry a revolving balance.
If Susan pays only the minimum payment of $20 per month, it will take her 11 months to pay off her balance.
If shares of Dynaco rise
above $150, the buyer of
the options wins and
Englebert is obligated to
sell 100 shares to the
holder for $150. But if they
never hit the strike price of $150, Englebert wins and gets to keep the $200 premium the buyer paid. If shares of Dynaco get closer to the strike price of $150, the buyer can resell the option and make a profit off his speculative bet, but if shares of Dynaco decline — widening the spread between the strike price and the underlying asset price — the price of the option falls.
$100 million
$2
$20 million
$10 million
– Minus
PRICE PER SHARE
EXPENSES
Equals =
$30 million
NET PROFIT
>$10B
Under the prudent investor rule, the managing investor is required to consider the provision of regular income, the needs of the trust’s beneficiaries, and the preservation of the trust’s savings. Among the principles stated in the rule are diversification, minimizing of fees and the balancing of income production and capital appreciation.
x
=
$10 Billion
PRICE/SHARE
MARKET CAP VALUE
NOT A LARGE CAP COMPANY
OUTSTANDING SHARES
PRICE/SHARE
MARKET CAP VALUE
A LARGE CAP COMPANY
=
63,000,000
$200
$12.6 Billion
Convertible preferred stock can be exchanged for common stock, but not vice versa.
Convertibility:
Anti-dilution:
Trustees are expected to analyze and make sound decisions that are compatible with portfolio distribution requirements, the level of risk tolerance and other factors pertaining to the trusts they manage. The nature and level of the investment risk should be compatible with the aims of the trust and its beneficiaries.
The shareholder has the right to redeem her shares for a predetermined amount called a call price.
Callability:
