Of all the difficult conversations financial advisors must have with their clients, risk is one of the most challenging. That’s because when advisors think of “risk,” it doesn’t always match their client’s understanding of risk. Yet, advisors and clients need to be on the same page in how they view risk because nearly all the mistakes investors make can be attributed to the mismanagement of risk—whether it’s misunderstanding risk, underestimating, or overestimating risk, or failure to consider all forms of risk.
Most clients’ understanding of risk centers on how far their portfolio value can fall before they begin to panic. Because people fear losing money more than they enjoy reaping financial gains, that perception of risk is virtually hard-wired into their brains. For your clients who have experienced severe market crashes of extreme volatility, those fears may be justified. As a result, their myopic view of risk leaves their portfolios vulnerable to other, possibly more damaging forms of risk.
How to Engage Your Clients in a Conversation About Risk
Long-term investing, with the goal of accumulating sufficient capital to secure a lifetime of income in retirement, requires proactive risk management and a firm understanding of the role risk plays in investment returns. That begins with a conversation about their perceptions of risk and how that would impact their investment allocation.
Understand Your Clients’ Perceptions of Risk
The first step in a risk management conversation is understanding your clients’ perception of risk and how it came about. Risk is a highly personal thing, often driven by emotions. To bridge your clients to a different way of thinking about risk, they need to trust what you are going to tell them. It’s essential to demonstrate empathy—that you can understand why they feel that way, and that they’re not alone in feeling that way. That kind of understanding helps your clients to set their feelings aside for the moment.
Discuss Risk Tradeoffs
Next comes the discussion about risk tradeoffs and their impact on their ability to achieve their financial goals. When asked about investing in the stock market, many clients might tell you they want to take as little risk as possible or no risk at all. That opens the door for a discussion about the different types of risk, such as inflation risk, interest rate risk, longevity risk, and how they can impact their long-term investments. Understanding that there’s no such thing as zero risk, that it comes down to trading off one risk for another, helps put the concept of risk in context and determine which risk makes the most sense.
Distinguish Between Risk Tolerance from Risk Capacity
With a better understanding of a client’s perception of risk, you can move into a discussion of risk tolerance and risk capacity. A client’s risk tolerance is a measure of the amount of risk they can tolerate to the point when they can no longer sleep at night. A risk questionnaire can flesh out how your clients are likely to behave during a risky event, such as a steep market decline.
But, answering such questions when your clients are calm and relaxed might produce a different answer when they are in the reality of a severe market decline. You still need to gauge your clients’ risk composure, which is the level of influence fear or greed can have on their risk tolerance. Your client’s risk tolerance might indicate they can withstand a 20% drop in the market, but how would they react when overcome with fear. When all is well in the market, they may feel as though they can tolerate more risk, or vice versa, which can be problematic.
Then there’s risk capacity, which is the amount of risk your clients need to take to achieve their financial goals. Risk capacity is a calculation using time frames, income requirements, and existing assets to determine the rate of return needed to achieve their goals. Ultimately, this rate of return information is used to construct an investment portfolio within the constraints of your clients’ risk-reward profile.
Using Technology to Find the Optimum Balance Between Risk Tolerance and Risk Capacity
If the amount of risk required exceeds the amount of risk your client is willing to tolerate, they risk coming up short in reaching their goals. Conversely, if their risk tolerance is greater than their risk capacity, they risk introducing undue risk into their portfolio. The financial advisor’s job is to pinpoint the optimum balance of risk tolerance and capacity.
Your clients need to know their optimal level of risk before choosing their investments. To help your clients understand why they may need to take more or less risk, you can show them several model portfolios to demonstrate the risk/reward tradeoffs for various asset mixes. StratiFi Technologies’ risk management software offers an easy and efficient tool to compare a portfolio against other models and benchmarks to adjust positions while showing your clients the upside or downside risk for each position in the model.
Clients rely on their financial advisors to provide the map to get them to their destination. A risk management process is like having a compass to tell them which path to take, and StratiFi’s risk management software is the GPS that proactively guides them along the way to keep them on track to their destination.
As the stock market continues its relentless climb to new highs, now would be the time to have this very important conversation with clients – to dig a little deeper beneath the surface to see if their risk perception aligns with their risk tolerance and they understand the risk tradeoffs. The conversation is much easier to have now, than when they are ready to run off the cliff with the herd.
Our PRISM™ risk analysis software uses a blend of risk tolerance questionnaires, historical market events, and current market signals to provide advisors with all the data they need to know their customers and plan accordingly. Contact us to find out how StratiFi can help your practice.