Over the long run, taking on a moderate-risk strategy typically results in higher returns. So why do clients want to roll the dice?
Recent positive returns can skew an investor's perception of risk. Just like at the gaming tables, people think they have a hot hand.
"There's an illusion of control, like you're on a streak; but the statistical odds don't bear it out," says Victor Ricciardi, assistant professor of financial management at Goucher College in Baltimore.
Clients who feel flush may convince themselves to take risks, while others who've suffered financial setbacks may become chancier in a bid to catch up. Either way, such clients may fault you when their portfolios don't return enough. So here are five ways to enlighten overly aggressive clients.
Frequently, clients don't perceive a decision as particularly risky, says Michael Nairne, President of Tacita Capital in Toronto. So you must provide evidence. "We'll take the actual smallcap exposure [the client is asking about] and back-test it, walking through how it underperforms, either in the sector or cyclically through market stresses," says Nairne. "History is illuminating."
Talk $, not %
Losing 20% due to a risky decision might have minimal resonance as markets yo-yo, says Nairne. Talking about an actual dollar loss—$200,000 if you've got a million-dollar account—puts risk into sharp relief.
Talk objectives, not dollars
For someone whose risk tolerance doesn't jibe with his time horizon—he's seeking quick returns or short-term gratification—frame what he's risking.
Could the worst-case scenario mean the client has to work two extra years and delay retirement? Could it jeopardize the home in the sun or the ability to travel? Painting a picture makes the risk real.
Mitigate the risk
Try to minimize potential losses, says Michael Himmelman, CFP, FCSI, of Citadel Securities in Halifax. Explain the upside and downside of a speculative security or fund, for example, and convince the client to get out if it falls below a certain price.
If you're a discretionary manager, you can automate a pre-arranged trailing stop order to get the client out if the equity goes below a set price floor.
Know when to step back
If a client wants to assume what he considers unacceptable risk, Nairne insists it be done in a separate self-managed account.
Yet you still need to know what the client is doing so you can alter your strategy with the rest of their portfolio if needed. It depends on the size of the bet.
Make sure the client understands any independent moves affect your future recommendations. In the end, it's the client's money and decision.
Sometimes, your arguments to rein in risk will carry the day. If not, walling off a risky venture can at least shield you from blame.
Originally published in Advisor's Edge
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