Clients witnessed risk in action in 2008, but have these lessons lingered? Risk is a layered concept. Although individual investors—even high net worth clients—acknowledge their balance sheets, do they truly recognize the forces behind them or even their own risk thresholds?

Advisor’s Edge hosted leading Canadian CFAs and business experts to examine just how deep that understanding goes, and how advisors can best present risk concepts to create truly informed investors.

AE: It’s often said that clients don’t really understand risk tolerance, or their own risk tolerance levels, until they actually experience losses. Is that true?

Milevsky: Quite a bit of research questions whether risk tolerance exists and whether it’s something that’s measurable. Hypothesizing about how they’ll behave under risky conditions and actually seeing their behaviour under risky conditions are very different.

Trainor: There is the financial capacity for risk and there is the emotional tolerance for risk. With financial capacity, I think clients have a relatively good idea of what they can withstand. But in terms of the emotional tolerance for risk, they don’t have an understanding at all. That’s what we saw in 2008 and 2009. People who were extremely sophisticated in the financial markets came to me and said, “I had no idea I would react this way.”

Milevsky: Part of the problem is that the questionnaires we’re using to ask about risk tolerance aren’t really capturing clients’ trust tolerance, primarily because it’s not about their experiences, it’s about their feelings. We have to differentiate between risk tolerance and risk capacity.

Franklin: The year 2008 gave us tremendous experience in risk. By the time people have significant wealth, most of them probably have had an experience in loss. One of the big lessons for the professionals is how to take what’s in people’s experiential data bank and draw that out so it relates to the investable portion of their financial portfolio.

Copeland: It’s like an armchair quarterback. Someone can sit in a chair and say, “I wouldn’t have made that play,” and that defines their internal risk tolerance. But risk behaviour changes when you actually have to invest, especially when faced with changing environments.

AE: What kind of anecdotes of risk experiences can you share? Everybody said they could take a 20% loss, for example, until it actually happened to them.

Milevsky: I don’t think it’s the 20%. They’re afraid it’s going to become 60%. It’s not that they can’t handle the risk, they can’t handle the direction.

Franklin: In 2008, we were looking at unthinkable events: Money markets had failed. Vehicles that were supposed to be safe weren’t. The banking system wasn’t safe. So the imagination could run amok: 20 could go to 60 could go to zero.

Copeland: Trust played a strong role too. A few of my newer clients who didn’t have as much trust were saying, “Get me out.” And a few of my older clients, who had been with me a long time, said, “I haven’t opened my statements in six months.”

AE: Do you have other thoughts or anecdotes that explain client behaviour and risk?

Trainor: Often, clients have very little experience of being an investor. So advisors should be going back to basic principles. They should be telling them that certain risk-return parameters are driving the market, and every 40 or 50 years, the wheels are going to come off, but it’ll come back eventually.

AE: When you’re dealing with people like that, what are some of the things you’ve done to work with them?

Franklin: We take a classic conundrum approach, where you feel emotional about something and you try to sort through the problem. You write down the specific issues, the pros and cons of various solutions, and then try to drive towards the one that best meets the financial objective of the client and their emotional capacity.

Copeland: People forget about the upside to risk, especially when they’re faced with negative returns, which then results in conservatives moving to a cash strategy and keeping their money under the mattress. Risk is a two-edged sword, and they’re only concentrating on one side. It doesn’t matter whether you talk about objectives or long-term. For clients, it is, “What do I have in my portfolio today, and can I survive with that over the next 10, 20 or 30 years?”

AE: What percentage of clients actually understand their risk levels?

Copeland: Most people want last year’s return. Everyone seems to know they have to take risk to earn return, but they don’t want to take that risk.

Franklin: The CFA Institute is dedicating a lot of resources to behavioural finance. It’s not that people don’t have an appreciation for risk, but they don’t have the right tools or financial literacy to make optimal portfolio decisions. How do I know my assets are safe? What should I ask to make sure my advisor isn’t going to run away with the money?

Trainor: Until you actually have bullets flying by your head, you’re not going to know how you’ll react.

AE: How can you stress-test clients to determine how much risk they can tolerate?

Milevsky: My experience is with people at seminars. It’s not that they don’t understand risk. It’s that they don’t understand why things happen, like why stocks fall. Why should this particular asset class be correlated with that asset class? That’s the concern. This is a socio-economic issue. At certain levels of wealth, not only do they not understand risk, they don’t understand capital markets. And they don’t really understand the functions of an economy. So they have a severe handicap to overcome before we can educate them about capital markets and risk and return trade-offs.

Trainor: We spend an awful lot of time educating them about the markets and portfolio structure in a way that we think they can deal with. You might have an NHL hockey player who’s making millions a year but never made it through Grade 12, versus the CEO of a financial institution. The conversations are totally different.

AE: How do you manage that as professionals? It’s got to be difficult to keep changing the way you present concepts.

Copeland: I spent most of my career in bond portfolio management. And the concept of prices going up and bond yields going down, bond yields going up and prices going down, and then you throw in duration—forget it. You can use a teeter-totter as an analogy, but people still just nod knowingly. They think of Canada Savings Bonds, where there’s no concept of opportunity or risk. If rates go up, you have opportunity costs. But it’s very difficult to broach that with the average client, even ones who have some background in finance.

Franklin: Financial literacy has not been part of most people’s training. That’s critically important, because it’s probably not going to go back to a time when the state takes care of you, whether it’s the corporate or the political state. We’re saying, “Here are things you should ask your advisor, here are things you should be thinking about.” There are books that present difficult concepts. The Richest Man in Babylon is a wonderful book written in the 1930s and that takes place in Babylonian times, and the messages in the story are just as applicable today as back then.

Trainor: Six or seven years ago we recognized that 30% of CFA members are associated with private wealth.

Franklin: That’s where the big pools of capital are. It was institutional, and it’s migrating over to the individual investor.

Milevsky: The CFP designation is trying to go after this exact audience. I wish there was more co-operation between these two organizations with designations because they’re both after the same thing, which is to help individuals make better financial decisions.

Franklin: We’re going to have to do a much better job of walking in the client’s shoes as a recipient of our services and ask, “How do these people work together on my behalf?”

Milevsky: I see it among undergraduates. There’s a kid who’s trying to figure out what to do with their career, and they really like the idea of wealth management. So do they go through the three levels of the CFA, do they go for the CFP, do they go for the CLU? More co-operation would be very helpful so we didn’t have to pick sides.

Trainor: I agree 100%. Depending on the door that you come through, you get the solution based on that door, which may not be the optimal solution for the client. Some people will never see an investment counsellor recommending an annuity, even though it might be the right thing for the client, because they’re going to lose $1 million or $2 million in assets.

Milevsky: And vice versa. The insurance advisors don’t have the statistical training to recognize true alpha if it hit them in the face. Think of the next generation. People in their 20s are trying to figure out the avenue they should take. And it’s tough.

Franklin: You have to pick one of them. I actually think you do a disservice by saying you can be a generalist.

Trainor: There’s a role for all those designations. I’d say probably one of the best places to start off would be as a CA. Because of their tax capacity, their analytical capability and the different areas that they work in, it’s a great training ground.

Franklin: You have to have an area of specialization. You want to be really broadly aware of the other issues and how they relate, and how you’re going to co-ordinate them. But at the end of the day it’s the investments that are the variable and that change dramatically. Not understanding what makes up financial products is a problem, because then you can’t have the conversation with the client about where the difficulties and opportunities are going to occur.

Milevsky: When you talk about risk tolerance, are you willing to have a conversation with them about what the best mortgage for them is? They may have a $1 million mortgage on their property. So you’re managing a $1 million portfolio, but they’re trying to figure out fixed floating cap, long-term, short-term—are you willing to have that conversation as well?

Trainor: An analyst can determine what the optimal capital structure is for a corporation, and in the same way an individual also has an optimal capital structure. That’s one of the things we’re working on right now—how to model those.

AE: The list of designations is growing. How do you get people to understand that you’re a professional, you’re here to help measure and temper their risk? Is that an education gap?

Milevsky: Branding. You need a campaign so anybody with any wealth understands that unless their advisor has a CFA designation, he or she is lacking some critical financial knowledge. Going into the bank or stumbling across someone on a golf course doesn’t mean anything. That’s one of the takeaways from the financial crisis.

Franklin: We haven’t articulated the fact that the client now truly owns their financial well-being, so it behooves them to educate themselves.

Milevsky: Do the higher net worth individuals need to be told that?

Franklin: You don’t need to tell the higher net worth clients. We use the concept of irreplaceable capital: What’s the probability you would be able to replace this capital you’ve either spent a lifetime saving up or you had the liquidity event. They say, “Not very likely.” And that changes the nature of the discussion.

Trainor: I don’t know if they know the questions to ask. They’ve asked for referrals from friends, but they don’t know how to package it all together. Especially if you’ve got lawyers looking after your estate trust planning, a portfolio manager looking after your portfolio and your CA helping you with your small business.

Copeland: A financial planner is supposed to do all that, but in Canada, it’s not that well defined. And people don’t like to pay for advice. That’s why the mutual fund industry exists, because there are a lot of hidden fees. Years ago, when the big corporations had people retiring, they sent them to financial planners. But that’s been cut out over the years. It’s also difficult to have one-stop shopping because many clients have long-term, trusted relationships with their lawyers, accountants and other professionals, and they don’t all work under one roof.

AE: The next question is about shifting more towards advice to your peers. How should advisors be assessing risk levels and what tools can help them do that?

Franklin: The CFA Institute created a private wealth body of knowledge. That’s one of the greatest tools. And there’s a list you can check off to say, “I do know about that or I’m not an expert in that field. I’ve now identified the mortgage, the insurance components and I do need to draw on other people’s expertise.”

Milevsky: Since we’ve continued to bring up the CFA, do you see the curriculum changing in the direction of things a CLU would learn?

Trainor: As a professional body, the CFA recognizes that if we have 30% of our members participating in private wealth, they have to know something that’s quite a bit different from the guys who are trading bonds or equities or are strictly institutional. If you are going to manage a portfolio, you have to do an investment policy statement. An integral part of constructing that is a person’s human capital—analyzing it and understanding the two principal risks: morbidity and mortality. So you’d better have an understanding of insurance.

Milevsky: One of the other designations that hasn’t come up here is the actuarial designation. They’re also trying to get into the space. Some started out working for large insurance companies but are now doing a lot of what you folks are doing.

Franklin: Actuarial science requires a lot of large numbers. The ironic part about actuaries going into wealth management is the institutional model doesn’t fit, because private individual
clients are absolutely not predicated on the law of large numbers. Actuaries deal with very long time horizons and results are averaged over a large number of lives. That’s exactly what doesn’t happen in an individual family. A lot of times, the reason institutional strategies fail the individual investor is not that they’re bad; it’s the lack of recognition of that individual nature.

AE: Is risk simply a collection of uncovered needs or is it more? How do you look at it and how do you get the client to look at it? How are those views different?

Trainor: It’s up to the advisor to sit down and work with the client and figure out what the true issues are. It may be they have a child with a disability, who’s going to have to be protected for 70 years. It’s up to the advisor to ask the
appropriate questions.

AE: That’s the thing—you talk about designations, you talk about questionnaires, you talk about all the stock stuff. Is part of your training on the job, and you learn by having these conversations?

Franklin: Our business is filled with analytical people. I think there’s a large component that can be trained around the empathetic tools that allow you to get out of a client what you need. Much of the work going on right now is architectural work: How do we take in all this information and put it in a framework of a portfolio that deals with all these components—whether it’s mortgage, insurance, human capital, the actual investments—and build something that really meets the clients’ needs?

Milevsky: We have financial risk aversion, and there’s also longevity risk aversion. The fact that a client may live to the age of 100 doesn’t faze them. They don’t want to plan for it. They’re longevity risk tolerant. Other people are longevity risk averse. They say, “What, there’s a chance I may make it to 100? That really worries me. I want to make sure I have enough if I get to 100.” How does that impact retirement planning?

Franklin: And it has huge investment, insurance and wealth implications. We need to be crystal clear on morbidity and mortality. We need to be crystal clear on longevity risk. Those kinds of conversations drive an investment and portfolio conversation.

Trainor: A study done out of the U.S. found that 50% of people aren’t going to work as long as they want to because of health reasons and a lack of employment opportunities. You may have somebody who is 60 and planning to work at a reduced capacity for another 10 years and all of a sudden they find out they’re going to have to start drawing on their portfolio today, not 10 years from now.

Franklin: BGI did a study on the preparedness of Americans in the 8th and 9th wealthiest decile for retirement. And guess what? Individuals in those deciles on average assumed their biggest asset, which is generally their real estate asset, is going to contribute to their portfolio. They say, “I have a $2 million house, I have $1 million in savings and I have a DC plan, so my retirement savings programs add up to another half million.” They haven’t done the accounting that says, “When I replace my $2 million house, it’s not actually a functioning asset because I still need a place to live.”

Milevsky: Would you be willing to fire a client?

Franklin: Sometimes you have to. And you have to be very honest about how the two of you are not a good fit because they’re looking for something that is inconsistent with what you believe is in their best interests.

AE: In terms of the clients you keep, do all of them come to you after being through the school of hard knocks?

Franklin: By the time it gets to us, the wealth becomes really relevant, because they’re approaching retirement and this is all their savings, so there’s a catalyst for them to be very focused.

Milevsky: So what are you telling the masses with only $30,000 in their RRSP?

Franklin: If you’re young, set up a savings program, and spend time on your risk profile. The magic of compounding interest can work for you, so you don’t need to take huge risks. If you’re 55, get used to working—you have to think very long and hard about your total portfolio and your expenses.

Milevsky: Anybody between the age of 40 and 60 sitting on a relatively small sum in their RRSP—unfortunately, there’s a very large group of them out there and they need help.

Franklin: Work longer, reduce your standard of living and by the way, you may have to sell the house.

Trainor: The numbers never work unless they reduce their cost of living. And often, they may have dependent children who are in their late 20s, early 30s, and the parents have never had the tough conversations with their kids.

AE: How can advisors show clients how to look at risk holistically?

Franklin: I think it requires being well educated, imaginative and brave to have the right conversation with clients.

Milevsky: Start using the language of finance more broadly, and start using common language with regard to the risks they face: Your house may burn down, you may live a long time and you may be unemployed. We all use different metrics and languages to discuss it. If we could somehow use the same language for all risks, maybe we could start thinking more holistically.