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Discretionary account

What Is a Discretionary Account?

A discretionary account is a type of brokerage or investment account where the account holder grants a designated professional, such as an investment adviser or broker-dealer, the authority to make investment decisions on their behalf without seeking prior approval for each trade. This arrangement falls under the broader category of Investment Management, allowing for more agile execution of an investment strategy by the professional. The core of a discretionary account is the transfer of immediate trading authority from the client to the financial professional, enabling them to buy, sell, and choose specific securities within predefined parameters.

History and Origin

The concept of granting discretionary authority to financial professionals has evolved alongside the financial industry itself, becoming more formalized with the advent of modern securities regulation. A significant milestone in the oversight of such relationships in the United States was the enactment of the Investment Advisers Act of 1940. This federal law was a direct response to concerns about investor protection following the 1929 stock market crash and the Great Depression. It established a framework for regulating investment advisers, imposing a fiduciary duty on them to act in the best interests of their clients and addressing potential conflicts of interest inherent in advisory relationships, including those involving discretionary authority.7 The Act provided legal groundwork for monitoring those who advise on investments and established who must register with state and federal regulators to dispense advice.

Key Takeaways

  • A discretionary account grants a financial professional the authority to make investment decisions without requiring client approval for each transaction.
  • This arrangement is established through a formal, written client agreement that outlines the scope of authority.
  • While offering convenience, discretionary accounts require trust in the financial professional due to the broad trading latitude.
  • Regulatory bodies, such as FINRA and the SEC, impose strict rules and oversight on discretionary accounts to protect investors from potential abuses like churning.
  • Investors maintain ultimate responsibility for monitoring their discretionary accounts and ensuring transactions align with their risk tolerance and investment objectives.

Interpreting the Discretionary Account

A discretionary account is interpreted as a mandate given by a client to a financial professional to manage a portfolio actively based on the client's stated goals and risk parameters. It signifies a client's trust in the professional's judgment to execute trades promptly and efficiently, without the need for constant communication and approval. This setup is particularly beneficial for investors who lack the time, expertise, or desire to actively manage their own portfolio management. The interpretation hinges on the pre-agreed terms, which define the types of investments allowed, the overall asset allocation strategy, and any specific restrictions the client wishes to impose.

Hypothetical Example

Sarah, a busy marketing executive, wants to invest her savings for retirement but has limited time to research stocks and execute trades. She decides to open a discretionary account with a financial advisory firm.

  1. Initial Consultation: Sarah meets with her assigned investment adviser, David. They discuss her financial goals, which include long-term growth for retirement in 20 years, her high risk tolerance, and her preference to avoid investments in fossil fuels.
  2. Agreement and Authorization: Sarah signs a formal client agreement granting David discretionary authority over her account. The agreement explicitly states her investment objectives, risk profile, and the environmental, social, and governance (ESG) restriction. It also details the advisory fees.
  3. Portfolio Implementation: Based on their discussion, David constructs a diversified portfolio for Sarah, primarily consisting of growth stocks and exchange-traded funds (ETFs) aligned with her ESG preference. He begins executing trades.
  4. Ongoing Management: Two months later, David identifies an opportunity to rebalance Sarah's portfolio due to market movements, requiring the sale of certain tech stocks and the purchase of new healthcare equities. Because he has discretionary authority, David can execute these trades immediately without contacting Sarah for approval, ensuring the portfolio remains optimized according to her long-term investment strategy.
  5. Regular Reviews: David schedules quarterly reviews with Sarah to discuss the portfolio's performance, significant market events, and ensure her objectives or financial situation have not changed.

Practical Applications

Discretionary accounts are widely used in various facets of the financial industry, offering convenience and professional oversight.

  • Wealth Management: High-net-worth individuals and families often utilize discretionary accounts for comprehensive portfolio management, delegating day-to-day investment decisions to their wealth managers. This allows for prompt reaction to market shifts and continuous adherence to the established investment strategy.
  • Institutional Investing: Pension funds, endowments, and other large institutions frequently grant discretionary authority to external asset managers to handle specific segments of their vast portfolios, benefiting from specialized expertise.
  • Trust Accounts: Fiduciaries managing trust assets often operate discretionary accounts to fulfill their obligations to beneficiaries, making investment decisions deemed appropriate for the trust's objectives.
  • Robo-Advisors: While often automated, many robo-advisory platforms operate on a discretionary basis, rebalancing portfolios and adjusting allocations without direct client intervention once the client's profile and preferences are set.
  • Regulatory Compliance: Regulators like FINRA strictly oversee discretionary accounts to prevent abuses. FINRA Rule 3260, for instance, mandates written authorization for discretionary power and prohibits excessive transactions (known as churning) in such accounts.6 The rule requires that each discretionary order be promptly approved in writing by the firm and that all discretionary accounts be frequently reviewed to detect and prevent transactions that are excessive in size or frequency, considering the client's financial resources and character.5

Limitations and Criticisms

While offering convenience, discretionary accounts come with inherent limitations and potential criticisms that investors must consider. The primary concern is the potential for abuse of authority by the financial professional. One significant risk is churning, where a broker engages in excessive trading in a client's account primarily to generate commissions rather than to achieve the client's investment objectives.4 This practice is illegal and violates regulatory bodies' rules, including those of FINRA. FINRA Rule 2150, for example, prohibits the improper use of customer securities or funds, as well as guarantees against loss and certain types of sharing in accounts.3

Another limitation is the potential for conflicts of interest, even if not outright illegal. An adviser might favor investments that benefit their firm or themselves, potentially at the expense of the client's best interests. While the fiduciary duty imposed by the Investment Advisers Act of 1940 aims to mitigate this, constant vigilance is still required from the client. Investors in discretionary accounts are ultimately responsible for the outcomes of transactions, regardless of profit or loss, and instances of brokers effecting unauthorized trades or acting outside agreed mandates have occurred.2 Therefore, clients should regularly review their account statements, understand the fee structure, and establish clear communication with their financial professional.1

Discretionary Account vs. Non-Discretionary Account

The key difference between a discretionary account and a non-discretionary account lies in who has the authority to initiate trades.

In a discretionary account, the financial professional (e.g., broker or investment adviser) has the pre-approved authority to make investment decisions and execute trades without seeking the client's explicit permission for each transaction. This is typically formalized through a written client agreement that outlines the scope of the professional's authority, investment objectives, and any restrictions. The professional can react swiftly to market changes and implement a portfolio management strategy without delays.

Conversely, in a non-discretionary account, the client retains full control over all trading decisions. The financial professional can offer advice and recommendations, but every buy or sell order must be explicitly approved by the client before execution. This arrangement provides the client with more direct control and oversight but requires them to be actively involved in decision-making and available to approve trades.

FAQs

What does "discretionary authority" mean in a financial account?

Discretionary authority means that you, as the account holder, have given written permission to a financial professional, such as a broker or investment adviser, to make trading decisions in your account without needing your approval for each specific trade. This includes deciding which securities to buy or sell, as well as the timing and price of those transactions.

Why would someone choose a discretionary account?

Investors often choose a discretionary account for convenience and to benefit from professional expertise. It's suitable for individuals who lack the time, knowledge, or inclination to actively manage their own investments. It allows the financial professional to respond quickly to market opportunities or risks without delays caused by needing client approval for every action, thereby streamlining portfolio management.

Are there risks associated with a discretionary account?

Yes, risks exist. The primary risk is the potential for a financial professional to misuse their authority, such as engaging in excessive trading (churning) to generate higher commissions. To mitigate these risks, regulatory bodies impose strict rules on these accounts, requiring written authorization and regular oversight. Clients should always review their account statements carefully and discuss any concerns with their adviser.

How is a discretionary account different from an advisory account?

While many advisory accounts operate on a discretionary basis, the terms are not always interchangeable. An advisory account refers to the service where an investment adviser provides ongoing investment advice, typically for a fee based on assets under management. A discretionary account specifically refers to the authority granted within that service (or a brokerage account) that allows the adviser to execute trades without per-transaction approval. Not all advisory accounts are discretionary; some may require client approval for every trade.