Discretion

What Is Discretion?

In finance, discretion refers to the authority granted to an investment professional, such as a broker, investment advisor, or portfolio manager, to make investment decisions and execute trades on behalf of a client without obtaining explicit approval for each individual transaction. This power is typically established through a written agreement and is a core component of investment management services⁵², ⁵³. Discretionary accounts are often favored by investors who may lack the time, expertise, or desire to manage their own portfolios actively⁵⁰, ⁵¹. The professional managing the account operates within predefined parameters and objectives set by the client, ensuring decisions align with the client's risk tolerance and financial goals⁴⁹.

History and Origin

The concept of investment professionals managing funds on behalf of others dates back centuries, but the formalization of "discretionary accounts" and their regulation is more recent. As financial markets became more complex and the volume of trading increased, the need for professional oversight grew. Early forms of discretionary power might have been informal, based on trust between individuals and their financial agents. However, with the rise of modern investment firms and the expansion of the securities industry, clear guidelines and regulations became necessary to protect investors.

For instance, the Financial Industry Regulatory Authority (FINRA) has specific rules governing discretionary accounts, consolidating and clarifying obligations for firms and their associated persons regarding the exercise of discretionary power. FINRA Rule 3260, for example, outlines requirements for written authorization and firm approval for discretionary trading, with an exception for short-term time-and-price discretion that lasts only until the end of the trading day⁴⁷, ⁴⁸. Similarly, the U.S. Securities and Exchange Commission (SEC) has provided interpretations regarding an investment advisor's fiduciary duty, emphasizing that while the scope of discretion may vary, the core fiduciary duty to act in the client's best interest cannot be waived⁴⁵, ⁴⁶. The evolution of these regulations reflects a continuous effort to balance the efficiency of discretionary management with robust investor protection.

Key Takeaways

• Discretion grants an investment professional the authority to make trading decisions without requiring client approval for each transaction⁴⁴.
• This authority is typically established through a formal agreement and operates within predefined client objectives and asset allocation guidelines⁴³.
• Discretionary accounts can offer convenience and professional expertise for investors who prefer a hands-off approach⁴².
• Regulatory bodies like FINRA and the SEC impose strict rules, including written authorization and a fiduciary duty, to protect clients in discretionary relationships³⁹, ⁴⁰, ⁴¹.
• While offering benefits, discretionary accounts generally come with higher performance fees compared to non-discretionary alternatives³⁸.

Formula and Calculation

Discretion itself is not a quantifiable financial metric with a specific formula. It represents an authorization or power. However, investment professionals operating with discretion often apply various financial formulas and calculations as part of their portfolio management strategy. These may include:

• Portfolio Weighting: Determining the proportion of each security within the portfolio.
  $W_i = \frac{V_i}{V_P}$
  Where:
  • (W_i) = Weight of security (i) in the portfolio
  • (V_i) = Value of security (i)
  • (V_P) = Total value of the portfolio
• Return Calculation: Measuring the performance of investments.
• Risk Metrics: Quantifying various types of risk, such as standard deviation or Beta.

These calculations inform the discretionary decisions made regarding the buying and selling of securities, including stocks and bonds.

Interpreting Discretion

Discretion implies a significant level of trust placed in the investment professional. For investors, understanding discretion means recognizing that while they relinquish day-to-day control, the advisor is still bound by the client's overarching investment policy statement (IPS) and regulatory obligations. The degree of discretion can vary; some clients might impose tight restrictions on certain asset classes or ethical considerations, while others might grant broad authority within a general investment mandate³⁷.

Interpreting the effectiveness of discretionary management involves regularly reviewing performance against agreed-upon benchmarks and ensuring that the advisor’s decisions continue to align with evolving financial circumstances. It's not just about the numbers but also about the qualitative aspects of the relationship, such as the advisor's responsiveness and transparency.

Hypothetical Example

Consider Sarah, a busy executive who wants her retirement savings professionally managed but lacks the time to monitor the markets daily. She decides to open a discretionary account with a registered investment advisor.

1. Initial Consultation: Sarah meets with the advisor to discuss her financial goals (e.g., retirement in 20 years), risk tolerance (moderate), and any specific preferences (e.g., avoiding certain industries).
2. Investment Policy Statement (IPS): Based on their discussion, the advisor drafts an IPS outlining Sarah's objectives, the chosen asset allocation (e.g., 70% equities, 30% fixed income), and the advisor's authority to make trades. Sarah reviews and signs this document.
3. Granting Discretion: Sarah provides written authorization, giving the advisor discretion to buy and sell specific stocks, Exchange-Traded Funds (ETFs), and Mutual Funds within the agreed-upon IPS and asset allocation without contacting her for each transaction.
4. Portfolio Management: When market conditions change, or new investment opportunities arise, the advisor can swiftly rebalance Sarah's portfolio or adjust holdings without delay. For instance, if the equity portion of her portfolio grows to 75% due to market gains, the advisor might sell some stocks and buy bonds to bring the allocation back to the target 70/30 split, all without calling Sarah for approval.
5. Regular Reporting: The advisor provides Sarah with regular statements and performance reports, and they have periodic review meetings to ensure the strategy remains aligned with her goals.

This allows Sarah to focus on her career while her investments are actively managed according to her long-term plan.

Practical Applications

Discretion is widely applied across various financial services and structures:

• Wealth Management: High-net-worth individuals often utilize discretionary accounts to delegate day-to-day investment decisions to professional wealth managers.
• Pension Funds and Endowments: Institutional investors frequently grant discretionary authority to external portfolio management firms to manage their vast holdings and execute complex strategies.
• Robo-advisors: Modern robo-advisors operate on a discretionary model, where algorithms make investment adjustments based on client input (risk profile, goals) without requiring continuous client approval. ³⁶This often aligns with a passive investment strategy.
• Managed Accounts: Discretionary authority is the defining characteristic of separately managed accounts (SMAs), where a dedicated manager oversees a client's specific portfolio.
• Financial Advising: Many investment advisor firms offer discretionary services, allowing them to implement their investment strategies efficiently and react quickly to market changes.
• Central Bank Operations: In the realm of monetary policy, central banks exercise discretion when setting interest rates or intervening in markets, which has broad implications for financial stability and asset management. For instance, the International Monetary Fund (IMF) has examined how discretionary trading, particularly by informed traders, can influence asset price volatility, especially when those traders participate speculatively based on private news.
  ³⁵

Limitations and Criticisms

While advantageous for many, discretionary management comes with certain limitations and criticisms:

• Higher Fees: Discretionary accounts typically incur higher management fees, often charged as a percentage of assets under management (AUM), compared to non-discretionary or self-directed accounts. ³⁴This can impact overall returns, particularly over long periods.
• Loss of Direct Control: Investors surrender direct control over individual trading decisions, which can be uncomfortable for those who prefer to be more involved or have specific views on market timing.
  ³², ³³* Potential for Misalignment/Conflicts of Interest: Although fiduciaries are legally obligated to act in the client's best interest, the potential for conflicts of interest exists. For example, a manager might be incentivized to trade more frequently (churning) if they earn transaction-based commissions, or to recommend proprietary products. ³⁰, ³¹Regulatory bodies like FINRA have rules in place to prevent excessive transactions in discretionary accounts.
  ²⁹* Reliance on Manager Skill: The success of a discretionary portfolio is heavily dependent on the competence, judgment, and integrity of the managing professional. ²⁸Poor decisions or a mismatch between the advisor's strategy and the client's unspoken expectations can lead to unsatisfactory outcomes.
  ²⁷* Underperformance Risk: Some studies suggest that actively managed discretionary portfolios, after accounting for fees, may underperform passive investment strategies or market benchmarks over the long term. ²⁶This is a core tenet of the Bogleheads investing philosophy, which emphasizes low-cost, diversified index funds over active management.
  ²⁴, ²⁵

Discretion vs. Non-Discretionary Accounts

The key distinction between discretionary and non-discretionary accounts lies in who holds the authority to execute trades.

In a non-discretionary account, while an advisor can still provide investment advice and recommendations, they cannot act on those recommendations without the client's express permission. ¹²The choice between the two depends heavily on an investor's desired level of involvement, financial literacy, and time commitment.

FAQs

What does "discretionary power" mean in finance?

Discretionary power in finance means that an investment professional has been given written authority by a client to make decisions about what, when, and how much to buy or sell within their investment account, without needing to ask for approval for each individual trade. ¹⁰, ¹¹This power is typically defined within a broader investment policy statement.
⁹

Who uses discretionary accounts?

Discretionary accounts are primarily used by individuals or institutions who prefer to delegate the day-to-day management of their investments to a professional. ⁸This includes busy professionals, retirees, high-net-worth individuals, and institutional investors like pension funds or endowments.

Are discretionary accounts regulated?

Yes, discretionary accounts are highly regulated to protect investors. In the United States, bodies like FINRA and the SEC establish rules requiring written authorization from the client and the firm, and impose a fiduciary duty on investment advisors to act in the client's best interest. ⁶, ⁷They also have rules against excessive trading or other abuses.
⁴, ⁵

Can I set limits on a discretionary account?

Absolutely. Even with discretion, clients can and should set specific parameters and restrictions on their accounts. ³This might include prohibiting investments in certain industries, maintaining a specific asset allocation (e.g., a maximum percentage in equities), or avoiding particular types of securities. The investment professional is legally bound to operate within these defined limits.

What is the main benefit of a discretionary account?

The main benefit of a discretionary account is convenience and professional management. ²It allows investors to save time and reduce stress by entrusting their investments to experts who can react quickly to market changes and implement a coherent portfolio management strategy without constant client consultation.¹