Chapter Two The Risks of Investing Do What You Will, Capital Is at Hazard

In 1830, Justice Samuel Putnam of Massachusetts wrote the words that were to become the foundation of the prudent man rule:

Do what you will, the capital is at hazard.… all that can be required of a trustee to invest is that he shall conduct himself faithfully and exercise a sound discretion. He is to observe how men of prudence, discretion, and intelligence manage their own affairs, not in regard to speculation, but in regard to the permanent disposition of their funds, considering the probable income, as well as the probable safety of the capital to be invested.

This message is equally valid today. Manage your affairs with prudence, intelligence, and discretion. Do not speculate. Consider probable income as well as probable safety of capital. Recognize that there is no avoiding risk of one kind or another. For instance, holding cash—or hiding it in the proverbial mattress—at best assures no earnings on your capital and at worst exposes it to erosion by inflation. So the question is: What kinds of risks are you prepared to take? This chapter provides you with the background to answer that question by discussing the two major categories of financial risk. First is the inescapable risk of price inflation, which applies equally to all classes of financial assets. Second are the risks to principal and to income, which can be controlled to a large degree by your choices among the three primary financial asset ...

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