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The 5 Levels of Discretion: How Much Control Should You Give Your Financial Advisor?

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The 5 Levels of Discretion: How Much Control Should You Give Your Financial Advisor?

Whenever you start a relationship with a new investment advisor or broker, one of the first things you face is the task of completing all the new account paperwork. Before you sign on, it’s important to understand that there are two types of investment accounts: discretionary and non-discretionary.

If you agree to a discretionary account, it means you’re allowing your broker or advisor to buy or sell investments without getting your consent every time, although they are still supposed to invest keeping your investment goals in mind. If you don’t want to give your advisors that much authority, you should choose a non-discretionary account. “Non-discretionary” means that the advisor will still offer advice and execute trades, but you’re the one who will call the shots. There are different levels of discretion you can give to your broker (see below), depending on how involved you want to be.

Sometimes you may not even realize there’s a discretionary agreement buried deep within that paperwork you’re about to sign. It can be a sneaky little section that defines your account as a discretionary account. Whether you know it or not, this discretionary language effectively amounts to a limited power of attorney. As harmless as it seems, many people are surprised when they learn after the fact that they’ve opted in to give discretionary authority to someone they barely know.

When economist and actor Ben Stein was a guest on my show “MoneyTrack” on PBS, he said he doesn’t recommend discretionary accounts for most investors until they really get to know the advisor and develop that level of comfort.

How do you know if you should allow your advisor to make investments on your behalf and without your permission? And what level of discretion is best.

Weigh the Pros and Cons

Pros

  • You’re busy and timing is everything. If you’re away for a long weekend, your advisor doesn’t have to reach you when an important decision needs to be made.
  • A discretionary arrangement with a fiduciary advisor often saves you on fees. Investment costs for discretionary accounts tend to be lower if your advisor is fee-based because they’re typically based on assets under management, thus motivating advisors to perform well. (If your advisor is fiduciary, he or she is required to choose only investments that are in your best interest, rather than those that are OK – but not best – for you but provide larger commissions for the advisor.)
  • Advisors can execute large block trades for multiple discretionary clients all at the same price, rather than in individual trades. This saves investors who might otherwise have come at the end of the list from paying more than those at the top of the list because their purchases come after hours of buys by previous investors, which drives the price up. This kind of price bump will, of course, reduce the return on your investment.
     

Cons

  • A discretionary arrangement requires a great deal of trust, which takes time to build up. Remember, you’re allowing a portfolio manager you’ve just met to invest for you.
  • Discretionary accounts can lend themselves to what’s called “churning.” The New York Attorney General warns about this practice, which just means that brokers are engaging in an unnecessarily high amount of trading because they are paid based on how many trades they execute rather than on performance.
  • You’re stuck with the decisions your advisor makes, whether good or bad. These are investments that can’t be easily undone if you’re unhappy.
     

The 5 Levels of Discretion

How much control do you really want over your day-to-day investing decisions? I like to use this scale of one to five to figure out whether or not you’re a good candidate for a discretionary account:

  1. Full discretionary status: You want a qualified, professional money manager to make all the investing decisions. You don’t want to know the details and take a total hands-off approach, allowing advisors to make all the decisions for you.
  2. A few restrictions: You set some ground rules, such as certain investments to avoid. Otherwise you allow the advisor to make most of the decisions with very few restrictions.
  3. Middle of the road: This allows the advisor to invest within the various asset classes with some restrictions, such as keeping a set ratio of bonds to stocks, but with freedom in most areas. You and your advisors may also set trigger prices to buy or sell a specific asset you favor.
  4. Strict restrictions: With this account, you set a very tight list of restrictions for advisors, such as keeping only to blue-chip stocks or requiring the broker to keep a set ratio of bonds to stocks. This is more of a collaborative relationship.
  5. Full non-discretionary status: In this situation, you must approve every decision before a broker is allowed to make a trade. This approach is for people who are looking to the advisor for validation or advice, and want their advisor to communicate every detail that affects them.
     

Even if you want someone else to manage your portfolio, it’s a good idea to set some parameters for your advisor to follow. Just don’t sign a discretionary-account agreement without seeing it expressly spelled out in the document.

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