Discretionary investing

Discretionary investing is an approach to portfolio management where a financial advisor or money manager has the authority to make investment decisions on behalf of a client without requiring prior consent for each transaction. This falls under the broader category of investment management. The professional is granted the "discretion" to buy, sell, or hold securities based on the client's pre-defined investment objectives and risk tolerance, as outlined in a client agreement. Discretionary investing allows for timely execution of an investment strategy, as the manager can react quickly to changing market conditions without needing to contact the client for approval on every trade.

History and Origin

The concept of discretionary investing has roots in the historical evolution of professional wealth management. As financial markets grew in complexity and the number of individuals seeking professional investment advice increased, the practical need for managers to act swiftly on behalf of their clients became apparent. This delegation of authority addressed the inefficiencies of requiring client approval for every transaction. The relationship between an investor (the principal) and their financial advisor (the agent) inherently involves a delegation of control over assets, which introduces the economic concept of the principal-agent problem. This problem arises when there are misaligned incentives or information asymmetry between the two parties, a topic studied by economists and financial theorists.,²¹,²⁰ Early forms of discretionary management often involved wealthy individuals entrusting their fortunes to trusted bankers or families who managed their assets without constant oversight. The formalization of this relationship, particularly with the growth of investment advisory firms and mutual funds, led to regulatory frameworks being put in place to govern discretionary authority and protect investors.

Key Takeaways

• Discretionary investing grants investment professionals the authority to make trades without obtaining prior client approval for each transaction.
• This approach aims to enable timely responses to market opportunities and risks, improving execution efficiency.
• A formal written agreement, often called a discretionary mandate, outlines the scope of the advisor's authority, the client's investment objectives, and their risk tolerance.
• Investment professionals managing discretionary accounts are typically subject to a fiduciary duty, requiring them to act in the client's best interest.
• Discretionary investing is a form of active management, contrasting with approaches where clients retain direct control over every trading decision.

Interpreting Discretionary Investing

Discretionary investing is interpreted as a relationship of trust and delegated authority in financial planning. For investors, it means entrusting their capital to a professional who will manage their asset allocation and trading decisions within a pre-agreed framework. For the investment manager, it signifies a responsibility to execute trades in line with the client's stated goals, such as capital appreciation, income generation, or wealth preservation, without needing to seek approval for every transaction. This interpretation emphasizes the efficiency gained in decision-making and execution, especially in fast-moving markets. It implies that the client has confidence in the advisor's expertise and judgment to navigate market complexities and seize opportunities without delay. The regulatory environment surrounding discretionary investing reinforces the importance of this trust by imposing strict rules on advisors regarding their conduct and record-keeping.

Hypothetical Example

Consider Jane, a busy professional who wants to invest for retirement but lacks the time and expertise to manage her portfolio daily. She approaches XYZ Wealth Management and decides on discretionary investing.

1. Agreement: Jane and her financial advisor, Mark, establish a discretionary agreement. This document details Jane's goal (long-term growth for retirement), her high risk tolerance, and the broad parameters of her portfolio, such as a preference for diversified equity and fixed income holdings, with no direct investments in speculative assets like cryptocurrency. The agreement grants Mark the discretion to buy and sell securities within these guidelines.
2. Execution: One morning, Mark observes a sudden dip in the stock market due to an unexpected news event, which he believes presents a buying opportunity for quality companies that align with Jane's investment objectives. Without needing to call Jane for her individual approval on each stock, Mark immediately executes purchases of several undervalued stocks and exchange-traded funds (ETFs) for her portfolio, consistent with her established investment strategy and risk profile.
3. Reporting: Later that day, Mark sends Jane a consolidated report detailing the trades executed and the rationale behind them. Jane reviews the report and appreciates that Mark was able to act swiftly on her behalf, potentially capturing gains that she would have missed if he had to wait for her approval.

This example illustrates how discretionary investing enables prompt action and continuous portfolio management without constant client engagement.

Practical Applications

Discretionary investing is widely applied in various segments of the financial industry:

• Wealth Management Firms: Individual investors with significant assets often grant discretionary authority to wealth managers who then handle the day-to-day management of their investment portfolios.
• Advisory Platforms: Many investment advisory firms offer discretionary accounts where clients delegate trading decisions to the firm's portfolio managers or through model portfolios managed by the firm.
• Brokerage Firms: Broker-dealers may offer discretionary accounts, which are subject to specific regulations. For example, FINRA Rule 3260 governs discretionary accounts, requiring written authorization from the customer and approval by the firm for discretionary power to be exercised, along with mandates for prompt approval of discretionary orders and frequent reviews of accounts to prevent excessive transactions.¹⁹,¹⁸,¹⁷,¹⁶,¹⁵
• Institutional Asset Management: Pension funds, endowments, and other large institutions frequently employ external asset managers on a discretionary basis, empowering them to manage specific mandates (e.g., a large-cap equity fund or a global bond fund) within defined parameters.
• Trusts and Estates: Trustees often have discretionary power to manage assets held within a trust, making investment decisions that align with the trust's objectives and beneficiaries' interests.
• Regulatory Compliance: Investment advisors registered with the Securities and Exchange Commission (SEC) are required to maintain detailed records related to discretionary power over client funds, securities, and transactions, as outlined in the Investment Advisers Act of 1940 Rule 204-2.¹⁴,¹³,¹²,¹¹,¹⁰ This ensures transparency and oversight in how discretionary authority is exercised.

Limitations and Criticisms

While offering convenience and potentially better execution, discretionary investing has several limitations and criticisms:

• Loss of Control: Clients cede direct control over individual trading decisions, which can be a psychological hurdle for some investors who prefer a hands-on approach.
• Potential for Conflicts of Interest: Although advisors are typically bound by fiduciary duty, the delegation of authority creates a principal-agent problem where the advisor's interests might not always perfectly align with the client's. For instance, some compensation structures, like performance fees, could incentivize excessive risk-taking.
• Fees: Discretionary accounts often involve higher management fees compared to non-discretionary or passive investment options, reflecting the ongoing active management and the advisor's expertise.
• Abuse of Authority: In rare cases, discretionary power can be abused, leading to unauthorized trading, churning (excessive trading to generate commissions), or investments that do not align with the client's stated goals. Regulatory bodies like FINRA and the SEC have rules in place to prevent such abuses.⁹,⁸,⁷,⁶,⁵
• Underperformance: Despite the potential for active management to outperform, a significant body of research suggests that many actively managed funds, including those run on a discretionary basis, consistently underperform passive benchmarks over the long term, particularly after accounting for fees.⁴,³,²,¹ This raises questions about the value proposition for some discretionary approaches compared to low-cost indexing.

Discretionary Investing vs. Systematic Investing

Discretionary investing and systematic investing represent two fundamentally different approaches to managing investments. The key distinction lies in the role of human judgment and emotion versus predefined rules and automation.

While discretionary investing relies on the expertise and intuition of a human manager to navigate complex markets, systematic investing relies on the consistent application of rules, often executed by technology.

FAQs

Q1: Do I lose all control over my investments with discretionary investing?

No, you do not lose all control. While the financial advisor handles day-to-day trading decisions, the scope of their authority is strictly defined in a written client agreement. This agreement outlines your investment objectives, risk tolerance, and any specific constraints (e.g., no investments in certain industries). The advisor must adhere to these parameters and report on their activities.

Q2: Is discretionary investing only for wealthy individuals?

While traditionally associated with high-net-worth individuals, discretionary investing services are increasingly available to a broader range of investors. Many financial advisor firms and online platforms offer discretionary management with varying minimum investment requirements, making it accessible to a wider client base seeking professional portfolio management.

Q3: How are fees typically charged for discretionary investing?

Fees for discretionary investing are most commonly charged as a percentage of the assets under management (AUM). For example, an advisor might charge 1% per year on the total value of the assets they manage for you. This fee structure aligns the advisor's compensation with the growth of your portfolio.