If there's one thing every client has in common it's this: no one enjoys losing money. And yet market downturns and other losses will occur—and that can leave you in a difficult position. Particularly if you haven't planned ahead.
What does “planning ahead” mean in a field where even the most insightful analysts struggle to predict fluctuations in markets and other areas of finance? It means two things.
1) Talk Openly About Risk
Too often, financial advisors shy away from the topic of risk because they don't like reminding their clients that not all investments work out. This aversion is understandable—you don't want to put your clients in a bad mood, do you? But avoiding a frank discussion of risk is, ultimately, the wrong choice.
In a recent interview with Michael Finke, PhD, founder of the Wealth Management Certified Professional® (WMCP®) at The American College of Financial Services, Nobel Memorial Prize-winning Stanford economist William Sharpe discussed the importance of talking about risk. Among a number of observations, he noted that financial advisors have a particularly bad habit of not talking about risk in long-term investments. Instead, they tend to tell clients that, over the long run, they'll earn X amount of money, so there's no need to worry.
“That shouldn't be allowed,” Sharpe says. “Most investments people choose have some risk.” Clients need to understand that risk, Sharpe says, and what the risk might mean for their lifestyle, or their bequest, or anything else they care about.
Watch the Full Interview with William Sharpe
As Sharpe makes clear, if you're not open about risk, you're doing your clients a disservice. But what's the best way to handle risk with your clients? The answer takes us to the second step of planning ahead.
2) Find the Right Balance of Risk for Your Clients
Many see a client's comfort with risk as an aspect of their personality. But risk tolerance also depends on risk capacity, which, in practical terms, means an individual's ability to experience financial loss and still attain their goals. For example, a client close to retirement with a small nest egg will have a different capacity for risk than a young investor with a well-established portfolio padded by an inheritance. Those two clients might have similar personalities, but they need a much different balance of their finances and investments.
Once you understand a client's risk capacity, you can factor in their risk tolerance. You are likely familiar with the risk tolerance questionnaires many firms and advisors use. These surveys are a simple way to get a snapshot of a client's tolerance levels and open a wider-ranging conversation about the client's financial needs and goals.
However, even if you understand a client's risk capacity and risk tolerance, you'll still need to understand how your client's risk perception will shape their decisions and their ability to meet their goals. For example, will the client who perceives investing as inherently dangerous and prefers stable assets meet his or her financial goals if they choose investments which are safe but only deliver a low rate of return? How will the client who chooses higher risk for higher returns feel if the value of their assets decline precipitously?
To gauge how a client's perceptions will impact their future—and to educate a client on those impacts—you should run through a variety of scenarios and outcomes to ensure you and your client make choices that align with their risk capacity, their risk tolerance, and their goals.
How Can You Improve Your Ability to Talk About and Handle Risk?
When it comes to properly handling the inherent risks your clients face, experience is valuable—but trial-and-error isn’t the only way to gain advanced skills. Earning a designation can also help you master risk management.
In the financial industry, designations can be quite valuable. In a recent study published in the Journal of Financial Planning, researchers found that consumers who valued designations, as well as those with higher incomes and investable assets, paid advisers more than those who did not. Obviously, you would like to cultivate these types of clients. But doing so isn’t just about holding a designation; it’s about applying the advanced skills a designation provides so as to offer better service on issues like risk management.
One such designation that can help you do that is the award-winning Wealth Management Certified Professional® (WMCP®) designation created by a team of financial researchers at The American College of Financial Services. Unlike many other designations, the WMCP® program is designed to teach advisors how to communicate with clients on a personal level and apply goal-based investment strategies that address a full range of goals, from education funding to future earnings potential to estate-planning and beyond. With such a focus on personalized service and advice, the WMCP® doesn’t shy away from the topic of risk, but rather embraces it and helps advisors like you learn to embrace it—and manage it—too.
This content is made possible by The American College of Financial Services; it is not written by and does not necessarily reflect the views of InvestmentNews' editorial staff.