What is a Discretionary Account? Definition, Formula, and Example
A discretionary account is a brokerage account where the client deposits funds and authorizes a designated broker or investment manager to execute trades without prior approval.
What is a Discretionary Account?
A discretionary account is a brokerage account where the account holder grants written authorization to a broker or investment manager to buy and sell securities on their behalf without requiring prior approval for each individual transaction. The manager has the legal authority to select assets, timing, and order size based on the client's stated objectives. This differs from a non-discretionary account, where the broker acts strictly as an execution agent and must secure client consent for every trade. Discretionary accounts are heavily regulated by the SEC and FINRA to prevent unauthorized trading and churning.
How it is Calculated and Managed
Discretionary authority is established via a formal Limited Power of Attorney (LPOA) document. The performance of a discretionary account is measured against a benchmark, and the manager's effectiveness is quantified using risk-adjusted return metrics. The primary calculation for compensation in these accounts is the management fee:
Annual Management Fee = Assets Under Management (AUM) × Fee Percentage
If a discretionary account holds $500,000 and the agreed fee is 1.5%, the annual fee is $7,500, billed quarterly. Brokers must pass suitability tests for every trade, ensuring the position aligns with the client's risk tolerance, time horizon, and financial situation. Margin usage in discretionary accounts is strictly capped by the broker-dealer's risk management protocols.
Worked Example
A high-net-worth individual opens a discretionary account with a wealth management firm. The client signs an LPOA authorizing the firm to trade a $2,000,000 portfolio with a mandate for "long-term capital appreciation" and a restriction against shorting equities. The portfolio manager identifies a technical breakout in MSFT and buys $200,000 worth of shares at $400. The manager does not call the client to ask for permission. The trade executes immediately. The manager holds the authority to rebalance the portfolio, sell the position if the thesis breaks, or adjust stop losses. The client receives trade confirmations after the fact.
When Traders Use It
Discretionary accounts are used by investors who lack the time, expertise, or desire to manage their own portfolios. They are standard in hedge funds, wealth management firms, and managed futures accounts. Institutional traders managing prop desks also operate with discretionary authority over firm capital. Retail traders do not use discretionary accounts for their own active trading; they use them for passive or professionally managed allocations. Brokers use discretionary authority to execute complex multi-leg rebalancing strategies without the latency of client communication.
Limitations and Common Misconceptions
A discretionary account does not give the broker unlimited power. The LPOA restricts the manager to the specific strategies and asset classes outlined in the agreement. A common misconception is that discretionary accounts guarantee outperformance. The manager has total execution authority, but they remain subject to market risk, behavioral biases, and systematic drawdowns. Another limitation is the conflict of interest. Fee structures in discretionary accounts incentivize managers to grow AUM rather than maximize percentage returns, potentially leading to conservative, benchmark-hugging behavior.