Be sure clients truly understand volatility before it comes

Financial advisers need to take times like these — of relative market stability — to remind clients what investment risk is and what volatility feels like.
Many clients don’t truly understand what investment risk is all about, and that makes it difficult for advisers to gauge actual risk tolerance.
One way to help evaluate a client’s risk tolerance is to make them imagine they’ve lost a certain amount of their portfolio, said Brad Klontz, managing principal at Occidental Asset Management.
“The emotional side of the brain makes most decisions and it doesn’t understand statistics and percentages very well,” said Mr. Klontz, who is a therapist as well as certified financial planner.
(More: How to help clients take on the right amount of risk)
If a client has a $1 million portfolio, ask him what he would do if it were to drop to $700,000, Mr. Klontz said. If he reacts in a way suggesting he’d want to sell to make sure he didn’t lose the rest, he’s going to need more conservative investments.
“By exposing clients to the experience of losing money, it gives them the visceral feeling of losing money,” he said.
He said advisers should be talking with clients at every meeting about risk and making sure investments are still appropriate, because risk tolerances change.
“Tolerance to risk is in fact volatile,” Mr. Klontz said.
(More: Don’t project your risk tolerance on client )
Richard Petersen, executive director of MarketPsych Data, agrees that people don’t understand what it would feel like to lose, say, 15% of their portfolio’s worth. Therefore, the adviser needs to make the potential loss tangible to the client.
For example, ask, “What would you do if you couldn’t pay for your son’s whole college education?”
At the same time, explain that there’s a solution even to the worst case, in this scenario, lay out how the client may have to take out loans to pay for the education or have the student do so, Mr. Petersen said.
It’s also important to explain the upside of risk because most people err on the side of not taking enough risk.
“In this case, explain how the upside potential could make it possible for the clients to fund college for their grandkids, too,” Mr. Petersen said.
Steve Atkinson, Loring Ward’s head of adviser relations, said advisers should explain to clients the importance of not overreacting to market volatility by selling.
“Don’t make the mistake of letting a temporary decline become a permanent loss,” he said.
John Brett, a managing director for Pershing, said advisers should use the relative market calm and slowness of the summer months to focus on educating clients, especially about risk.
He recommends advisers either do so during a meeting, or use a webinar to make the description of risk and reward a visual experience.
“With all the new sources of investment information, like social media, it’s all the more important for advisers to have educated their clients on risk,” Mr. Brett said.