Lesson

Discretion refers to the authority granted by a client to an investment adviser to make investment decisions on their behalf without obtaining prior consent for each transaction. This authority must be granted in writing and is subject to various regulations and ethical practices to protect client interests.

Practice Question #1

Which of the following best describes discretion in the context of client funds and securities?

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Terms

Discretion:
The authority granted by a client to an investment adviser to make investment decisions on their behalf without obtaining prior consent for each transaction.
Discretionary Account:
An account in which the client has given the investment adviser discretion to make investment decisions, as opposed to a non-discretionary account where the client retains control.
Trading Authorization:
The level of authority granted to an investment adviser to execute trades in a client's account, which may be limited or full.
Limited Power of Attorney (LPOA):
A legal document that grants an investment adviser the authority to make investment decisions on behalf of a client.
Full Power of Attorney (FPOA):
A legal document that grants an adviser complete authority to make decisions on behalf of a client.
Investment Policy Statement (IPS):
A document that outlines the client's investment objectives, risk tolerance, and constraints, as well as the adviser's responsibilities and investment strategy.

Practice Question #2

What is the primary legal obligation of an investment adviser when managing a discretionary account?

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Real-World Example

An investment adviser with discretion over a client's account may decide to sell a stock that has reached its target price and use the proceeds to purchase a bond that offers attractive income potential. The adviser makes this decision based on their analysis of the client's portfolio and the current market conditions without consulting the client for approval.

Practice Question #3

Which of the following is an unethical practice in the context of discretionary accounts?

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More Detail

- Activities permitted with limited discretion: These are actions that an investment adviser can take on behalf of a client without obtaining specific consent for each transaction, but within certain boundaries set by the client. - Activities disallowed with limited discretion: These are actions that an investment adviser cannot take on behalf of a client without obtaining specific consent for each transaction, even if they have limited discretion. - Activities permitted with full discretion: These are actions that an investment adviser can take on behalf of a client without obtaining specific consent for each transaction, as they have been granted full discretion by the client. - Activities disallowed with full discretion: These are actions that an investment adviser cannot take on behalf of a client, even if they have been granted full discretion, due to legal or regulatory restrictions.

Practice Question #4

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More Detail Examples

- Activities permitted with limited discretion example: An investment adviser can buy or sell securities within a specific asset class as long as they stay within the client's risk tolerance and investment objectives. - Activities disallowed with limited discretion example: An investment adviser cannot withdraw funds from a client's account or change the client's investment objectives without obtaining specific consent. - Activities permitted with full discretion example: An investment adviser can buy or sell securities, change asset allocations, and make other investment decisions without obtaining specific consent from the client. - Activities disallowed with full discretion example: An investment adviser cannot engage in self-dealing, such as buying securities from their own account and selling them to the client's account at a higher price.

Practice Question #5

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Pitfalls to Remember

- Activities permitted with limited discretion pitfall:
Investment advisers must always act in the best interest of the client and should not use their limited discretion to engage in excessive trading or other activities that may generate fees for the adviser but not benefit the client.
- Activities disallowed with limited discretion pitfall:
Investment advisers should not assume that they have the authority to make certain decisions without obtaining specific consent, as this could lead to regulatory violations and potential legal issues.
- Activities permitted with full discretion pitfall:
Investment advisers must still adhere to the client's investment objectives and risk tolerance, even when granted full discretion, and should not use this authority to engage in activities that may not be in the client's best interest.
- Activities disallowed with full discretion pitfall:
Investment advisers should be aware of the legal and regulatory restrictions that apply even when they have full discretion, as violating these restrictions can lead to penalties and potential loss of their license.

Practice Question #6

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Practice Question #7

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Practice Question #8

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Practice Question #9

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