Talk to clients about risk

Some clients have lost up to 25% or more of their portfolios in the last six months. No wonder some of them would like to speak with their advisors. These conversations should inevitably lead to a discussion about risk.

If clients weren’t taking risk seriously before, they sure are now, and advisors should take advantage of this opportunity to discuss risk again. We asked a few seasoned advisors about the most effective ways they know to explain risk, and how they know when clients understand it.

How do you explain risk?

“We really talk about how much they are willing to lose to achieve their goals. One exercise we take clients through is ‘the boat is sinking’ question: How low will you allow the boat to sink before you jump? With $1-million would you jump after losing $30,000 (or 3%) or $100,000 (10%) or $500,000 (50%) or somewhere in between? “

— Brian Wruk, certified financial planner, Transition Financial Advisors in Alberta

“I think the first issue is seeing how the clients define risk for themselves. It’s not up to me to define it. We provide them with the definitions and ask them to rank the risks — longevity, market volatility, disability — based on their own lives, so we can understand them better. From there, we can decide on a plan.”

— David Wm. Brown, certified financial planner, Al G. Brown and Associates in Toronto

“Clients have come to understand risk as: How far can my portfolio fall in value before I really start to worry? We have to factor that into our perspective and ask if the client has the time and the psychological fortitude to make up for any losses. If not, their tolerance for risk may be lower than expected and capital preservation becomes the focus for the portfolio.”

— Cynthia Kett, a chartered accountant and certified financial planner with advice-only firm Stewart & Kett Financial Advisors Inc. in Toronto

“We tend to focus on the very big picture. First we ask what risk means to them. We spend a lot of time using questionnaires and surveys to pinpoint their risk personality. Then I talk about what we think risk means. In general, it means not being able to accomplish what you want to (goals), whether we’re talking about work, family or financial goals. It’s about their vision [and how different risks will impact that vision]. We spend a lot of time talking about that.”

— David Luke, a certified financial planner with Wellington West Financial Services Inc. in Manitoba

How do you improve a client’s understanding of risk?

“You re-emphasize it in the client’s Investment policy statement, which includes some of the gains and losses found after back-testing the proposed portfolio. That way, when markets are down 10%, you can tell the client to turn to page 4 and see that their portfolio, when back tested, reached a low of -28%. They can see this isn’t unexpected.”

— Wruk

“We try to use a more holistic approach and get clients to think about what they want to achieve in their lives. We break risk down into three components: Personal risk (health-related problems and job loss), property risk (issues with your house) and portfolio risk. When it comes to portfolio risk, we explore how they would react to certain losses.”

— Luke

“When I talk about risk I try to use examples and make it very real for the client. In light of recent events, we have to take a fresh look and ask: What is your tolerance now and going forward? We then make investment decisions based on their specific needs, questions about what the funds will be used for, how soon they will be needed and what asset classes match their current tolerance for risk.”

— Kett

How do you know when they’ve understood risk?

“I wouldn’t say they truly understand risk and I’m not sure they ever will. But I think they have reached an understanding of it when they call me and ask why we set up asset allocation like we did and how, long-term, that will assist them in achieving their goals.”

— Wruk

“I think everyone inherently understands risk. When you walk across the street without a crosswalk, you’re taking a risk. Really, risk is about what concerns the individual.”

— Brown

“You just can’t. If anything, risk is a personal thing. It’s imperative that advisors nail down what risk is to the specific client sitting across from them. Once they go through a situation like the recent downturn, they should go back to clients and ask how they feel about risk now.”

— Luke