The risk list

By Kate McCaffery | March 10, 2009 | Last updated on March 10, 2009
6 min read

It’s generally accepted that having clients invested in properly diversified portfolios reduces their exposure to downside risks. Interestingly, adhering to this course of action across all client portfolios could also reduce downside risks for an advisor’s book of business overall.

To get to this point, though, it’s necessary to discuss risks with clients, provide education about modern portfolio theory where needed, invest in the philosophy, or any philosophy for that matter, and get them to mentally invest in the idea as well.

No matter which strategy or philosophy you go for, an examination of risks, both with clients and in your practice is necessary.

“[Know your client (KYC)] has been around forever,” says Bill Donegan, chief compliance officer at Worldsource Wealth Management. “It’s a fundamental thing in the industry. You drive on the right hand side of the road; you know your client’s risk tolerance and investment objectives. It’s fundamental.”

Client risks are outlined in questionnaires but, as Donegan points out, questionnaires won’t tell an advisor whether the client has two college-aged children at home who need assistance paying their tuitions, they plan to buy a house in five years or the client’s spouse is terminally ill.

“I’m not sure the questionnaire is all that effective,” he says. “You can ask how you would feel if you lost 20% or 40% — of course I don’t want to lose 20% of my money. No I don’t want to lose 40% of my money. People are obviously going to say no. The assessment of risk tolerance is really something that should be done carefully and it should be done after a thorough discussion with clients about their needs and objectives.”

If there is any doubt about whether an independent advisor or firm’s KYC process is sufficient, the Mutual Fund Dealers Association of Canada issued new suitability guidelines last year, almost a primer on the topic, in Member Regulation notice MR-0069. In the 27-page document, available for download here, the MFDA spells out processes and expectations and even provides sample information forms.

From the asset management point of view, Jason Pereira, financial planner at Woodgate Financial Partners and IPC, says he first looks at the regular risk profiling questionnaires; the client’s age, income, knowledge levels, investable assets and net worth; time horizons; and the cost of returns.

“That conversation lasts a little while because people really don’t know what to expect. Some people have ridiculous concepts of 20-30% returns,” he says. “It’s a matter of putting it into context. My old trick, of course, is the question: If you give me $100,000 today and I give you $200,000 in 10 years, will you be happy? They almost always say yes — that’s only 7%.”

Following that, he talks with clients about inflation, interest premiums over inflation and risk premiums on equity. The conversation goes beyond this as well. “We speak about their previous experiences: what they liked and what they didn’t like about it. We also make sure they are investing with some real timeline — I won’t put a single penny into equity unless they have at least a five-year timeline. Historically, the worst-case scenario for a balanced portfolio is zero [break even]. No one wants to see a zero return over five years but if we get even one major market correction like this one, you at least make your money back.”

Other client and business risks are less obvious (decidedly less obvious, particularly on the business side).

Client risks

Over-reaction: It’s a shock to the system to see net-worth numbers get dramatically lower on quarterly statements, especially after such a long period of growth that lulled people into believing that asset growth was, and should be, a constant in their lives. Some people are willing to simply pull up all roots and change advisors when this happens. Others want to change plans in reaction to the news, believing that something in their plan needs to be fixed. “We actually spend a lot of time focusing on how they’re going to cope with the downside — more than anything else,” says Pereira.” [Their plans] might be working exactly as they should.”

Fear: Sensationalism sells, but it’s worth pointing out that this downside is a natural reaction to the hey-day where clients “couldn’t possibly lose money,” if certain experts were to be believed, or that “a monkey throwing darts at a list of tech stocks could do better than a portfolio manager.” Fortunately, this notion seems to have subsided, but in recent months some were also using the word “depression” to describe the current situation. “I’m sorry, during the depression, 30% of the workforce was out of work, we had famines and all kinds of crap that created the situation,” he says. “We are not in the same situation now. Even to compare one to the other is absolutely ludicrous.”

Market timing: Much like the urge to tweak or completely change investment strategies in reaction to market conditions, many are feeling the strong pull to park assets at the bottom and wait for things to turn around, which generally causes clients to lose out on good days, not to mention any dollar-cost-averaging benefits they might be set up to receive.

Business risks

Clients (and would-be clients): Pereira admittedly dogmatic talk throws into sharp relief one risk that is often overlooked or ignored during the pursuit of new clients — the risk posed by clients themselves. Unhappy clients, or those who don’t hold the same beliefs or philosophy used in your practice, are potential liabilities. If you spend too much time with lawyers, you might think the threat of a lawsuit is imminent, but even if discontent never makes it to the formal complaint stage, people talk about their unhappy experiences with friends, colleagues and family. If you adhere to very strict asset management policies, finding the right “fit,” clients willing to buy into the practice become even more important.

Market risk: “We are unbelievably exposed to market risk in our business structure,” says Pereira. “I’ve heard of advisors who are looking to retire but their portfolios are now down 40% so their book is worth 40% less.” As mentioned before, his solution is strict adherence to the practice of creating diversified portfolios that include a healthy contingent of bonds.

Related stories

More than one way to think about risk Welcome to the flip side Building a better risk profile The risk list Talking to clients about risk

Return to the Revisiting risk homepage

Compliance: Mis-profiled clients, paperwork and product risks all fall into this category. Most notably, Donegan says advisors need to pay particular attention to products that appear to be low risk. Mortgage investment corporations, asset-backed investments, viatical-type investments, offering memorandum investments that invest in private placements and other risky investments are all exempt market products that appear to deliver better returns, but which have “extreme amounts of risk built into the structure.”

“There are a bunch of things out there that look good on the surface, but when you start digging into the fine print, they’re risky structures.” Although there is a tendency to rush into products that promise returns above what a typical GIC will offer, Donegan says, “retail investors probably shouldn’t be there … the underlying asset may very well be mortgages to borrowers who can’t get a loan from the bank. You’ve got to look at that very carefully.”

Leveraging: Although leveraging appears to be an attractive strategy when markets are going up, in a declining market it creates a big risk for advisors. “I think a lot of people who get into leverage plans don’t fully understand what can happen if the securities decline in value and there’s a margin call.”

Overall, he says advisors need to be thinking about all this and proactively making contact with clients to explain things. “If anything, I think this will solidify the relationship — if they’re communicative and explain things,” he says.

As far as risk is concerned, though, there is simply one bottom line: that risk and reward are inextricably tied together. “I think that’s the biggest thing clients need to understand. There is no free lunch. If someone is promoting something with significant returns, you’ve got to understand that you cannot escape risk. If you move money into that type of product, you’ve got a chance of losing significantly as well.”


Kate McCaffery