"What is the right amount of risk in my portfolio?"
This is a question you may be asked on a regular basis, especially as the conversation turns to precious metals, penny stocks or certain bonds.
However, this is also a trick question. There is no generic answer for the right amount of risk for your clients' portfolios. It is very much on a case-by-case basis, and it doesn't just depend on their preferred investments. The real question, on the other hand, is when is risk too much for your clients to handle.
Every investor deals with risk on a daily basis. As their financial advisor, it is up to you to ensure they don't have too much on their plates - or that they have enough. Here is how you can help your clients evaluate their relationship to investment risk:
Go beyond the type of investment
Sure, select investments are more secure than others. But, this doesn't tell the whole story. Investors have to analyze their risk tolerance, their portfolio's risk tolerance and several other factors before determining which investment is right for them.
And, as a financial advisor, you can help them with this goal. For starters, you'll need to look beyond the type of investment. A key question is to ask how much money your clients have to invest - and how much of that they are willing to lose. Naturally, risky investments have the potential for a greater reward, but that can't be achieved if your clients aren't willing to gamble a bit.
This is where their mentality and personal situation come into play. There are two main factors that will drive whether or not your clients can accept a risky investment:
- Desire - Your clients have to want that investment; it can't be forced on to them. Or worse, it can't be done as a last-ditch effort to make money.
- Time - Your clients need time to invest with risk. For example, a 60-year-old client with a risk-heavy portfolio has only a few years before retirement to rebuild, should something go wrong. A 30-year-old, however, has decades.
Consider clients' fear of loss
What is the loss aversion coefficient? According to Princeton University professor Daniel Kahneman at the IMCA 2015 New York Consultants Conference, it is how clients are more sensitive to losses than gains.
Wealth Management contributor Diana Britton attended the IMCA conference, and she reported that Kahneman argued the loss aversion coefficient can impact a client's relationship to risk. For instance, some people are more afraid of losing money rather than planning ways to manage their wealth. This can affect how they think and which investments they deem worthy.
Kahneman also spoke about the hindsight phenomenon, where clients consider an event to have an obvious outcome only after the fact. "It induces us to believe the world is a place we understand," Kahneman said at the conference.
As a result, clients may make financial decisions based on a misplaced confidence. If this is done, they could easily make the wrong decision about an investment. Help them stay the course by addressing their opinions of specific returns and whether or not they place too great a value on loss. According to Britton, you may want to ask how much loss clients are willing to take before they look for another strategy. If the number is small, that risky investment isn't right for them.
Help clients' through tough times
Risky investments aren't for everyone. Even clients who seem willing - and who have the time and money - are subject to a bit of panic at the latest news story. How you react can ensure they never lose trust in your guidance.
With that in mind, here are several methods to help your clients avoid that dreaded financial freak out:
- Develop a clear financial plan - You can tell if your clients are more tolerant of risk by simply looking at their financial plan. If you've developed one that is clear and concise, it will easily illustrate their ability to maintain lifetime income without a dependence on their investment returns.
- Be upfront about market fluctuations - Your client may look at their portfolio and see that there is only a small chance that it will drastically decline over a 10 year period. However, this is clouding the fact that at least one of those years it will decline, you just don't know when or by how much. Being upfront about that distinction will help your clients remain calm should a problem arise - and it will improve their risk tolerance.
- Consider their history - Last, you should look back into your client's past. One silver lining of the Great Recession is that it gave financial advisors insight into how their clients react to market problems. If your clients didn't handle the recession well, they may not be the best candidates for risky investments. However, if they were calm and collected, they might be better prepared.
Take a look at the whole picture
When it comes to risk tolerance, the last thing you want to do is to have an incomplete picture of your clients. You instead want to be able to look at:
- Their history with risk
- Their current financial plan
- Their personal profile
This will help you accurately gauge your clients' ability to manage risk, and if they have a healthy relationship to risk. Then, you can continue to craft an ideal wealth management strategy from there.