When you hear the term risk, does your heart skip a beat? Perhaps the thrill of doing something risky, like taking Vegas head-on by doubling down on blackjack or going all-in with a bluff, is tempting. Yet for many people, particularly when it comes to finances, the term “risk” may not be quite as exciting. Especially if those people are your clients.
Of course, virtually every investment has some level of risk associated with it. And in certain situations, assuming greater risk to potentially reap greater rewards makes sense. That’s why it’s vitally important for advisors to know how to talk to clients about their risk tolerance and current level of financial risk.
Risk tolerance is one of the most common topics clients don’t fully understand, and study after study has proven that clients don’t understand financial jargon the way we think they do, so it’s imperative for advisors to break down “risk” in a way that makes sense to the client.
Here’s how to do it.
Explaining financial risk tolerance to clients
Before making any assumptions about what your client does or doesn’t know, simply ask them if they’re familiar with the concept of risk tolerance and how comfortable they are discussing their own position on the risk tolerance scale. If they give you a confused look or admit they aren’t super knowledgeable about the topic, you’ll know you have some explaining to do.
We recommend starting with the background and basics of risk level tolerance, then providing examples or analogies as necessary to help them understand.
While the stock market is unpredictable, it has a natural tendency to ebb and flow over time. There will be periods of intense growth (bull markets) and periods of dramatic losses (bear markets)—and clients need to have a realistic understanding of how the market swings as time goes on. Make sure your client understands that stocks can be very volatile in the short term, so it’s important for them to maintain good long-term decision-making and not immediately sell, sell, sell when there’s turbulence on Wall Street.
Once you’re confident that the client understands the natural flow of the stock market and won’t run for the hills the first time they see a substantial loss in their account, you can begin delving into the details of risk level tolerance—starting with the risk tolerance scale. But before you begin, it may help to provide an analogy or frame of reference they can use to understand the various levels of risk tolerance as you discuss it.
One way to think about risk tolerance is in terms of professional football. Players always face a level of risk when they take the field, mostly in the form of injuries. For a young player, the potential to make a lot of money may far outweigh the potential risk of getting injured. The first few injuries the player sustains may be "worth it" in their eyes because the potential to keep making money is so high; as they get older and their body can’t recover from the injuries as quickly or easily, they may become less tolerant of that risk.
Investing is similar. Young investors may be willing to take on higher levels of risk through a more aggressive mix of investments to maximize their potential returns, but as they get older and closer to reaching their retirement, a bear market may have a more significant impact on their account—one they may not be able to fully recover from. Most investors are not tolerant of this risk. Instead, they want to move their focus to a more conservative approach and protect their assets by minimizing risk in the event of a market downswing.
Levels of the financial risk tolerance scale
Once clients understand this concept, it’s time to really get into the details of risk level tolerance and the risk tolerance scale. Use easy-to-understand language, like:
Conservative risk tolerance
- Willing to take minimum risk and accept minimum potential returns—little to no risk in investment portfolios
- A conservate strategy may be best suited for investors who are planning on withdrawing money from investments in the near future (under five years)
Moderate risk tolerance
- Willing to assume some risk to principal investments, but adopts more of a balanced approach to potential growth and loss
- A moderate strategy typically works for investors with a moderate amount of time left before they plan to access the funds (five to 10 years)
Aggressive risk tolerance
- Seeking to achieve maximum potential returns and willing to assume maximum risk
- An aggressive strategy is typically best-suited to younger clients with plenty of time, who don’t plan on needing the money any time soon (more than 10 years)
When trying to explain the various levels of risk tolerance in a way that resonates with your clients, you may need to get creative. Instead of using potentially confusing jargon, you may consider dusting off a few well-known clichés.
For example, you could help explain what the risk tolerance scale is with a “fund growth vs. sustain” approach. Or what it means to have an aggressive risk tolerance by using phrases like “no pain, no gain” or “having an ‘in it to win it’ mindset.”
Finally, once your client understands the background and basics of financial risk, you can begin measuring their risk level tolerance.
You might also be interested in: How to build relationships with clients as an advisor
Measuring your clients' risk tolerance level
When assessing your clients’ risk tolerance level, you’re essentially asking them, "What’s the worst thing that could happen to your investments before you would panic and sell them off?"
Would a 10% loss annually prompt them to sell off their investments? What about a 5% loss monthly? And vice versa, what type of gains would they be willing to withstand that risk for? In their mind, would a 20% return over three years make up for any potential losses? What percent return annually would they deem acceptable?
If you’ve been working with your client for some time, you may already have an inkling of what their risk level tolerance is, but it’s important to truly understand where exactly on the risk tolerance scale your client falls. If you aren’t sure exactly where they’re at, start by asking these questions:
- How anxious do you feel about the potential to lose money in the stock market?
- Would you be tempted to sell your investments if they lost money over the course of one year?
- How many more years do you plan on working before you retire? (Helps determine time horizon)
- Are you willing to take on above-average risk to get above-average potential returns? (Helps determine risk comfort)
Once you have the answers to these questions, you should be able to place them on the risk tolerance scale and talk about what type of fund portfolio would be most appropriate for them. Remind them that as they get older, they’ll want to re-evaluate their level of comfort and adjust their fund portfolio as necessary to reach their overarching retirement goals.
Helping clients understand financial terminology and topics certainly takes time and effort, but doing so will go a long way in showing clients you really care about their financial future and retirement outcomes. And once your clients understand how valuable you can be in helping them reach their long-term financial goals, you’ll enjoy a stronger relationship and higher level of trust—ultimately leading to higher client retention and additional referral opportunities.
If you need any help along the way, we're here to support you. Our network of retirement professionals can assist with any retirement plan needs your clients have. Contact us today at 800-345-6363.
