These rules provide trustees with the great advantage of modern portfolio theory. When the trustee is responsible for investment of the assets of a public employee retirement system, he or she must invest as a prudent investor invests his or her own assets. Prudent investment is a fiduciary duty. A prudent investor takes all factors into account in considering investment decisions, such as general economic conditions, effects of inflation or deflation, expected total return from income and appreciation of capital, and the role that every investment fills in the entire portfolio. There is a positive obligation to diversify investments, unless special circumstances indicate that it is not prudent to do so.
Diversification is the best method for reducing risk of loss.
The trustee must make a careful risk-return analysis in light of the objectives of the retirement system, including the income needs of that system. The availability of a broader range of investments and diversification means risk can be safely and significantly managed with the prospect of much greater return. Since most of the public employee retirement systems are backed by state and local governments, if they fail to generate the income to pay retirement benefits, the taxpayer inevitably assumes the burden. Thus prudent investment reduces taxpayer risk, as well. As a corollary to prudent investment obligations, the trustee's performance in investment is measured by the performance of the entire portfolio, not just the performance of individual investments.