When it comes to your client’s investment or retirement portfolios, there’s always some level of risk. Because of this, measures such as diversification, asset allocation, and dollar cost averaging are so important. But how can you teach your clients about the importance of managing investment risk without having them fall asleep? And what happens when markets become extremely bullish, and portfolios underperform the sensationalized media coverage?
Here is how we as financial advisors can help our clients manage risk and help them prepare for upcoming events like market crashes, stock corrections, and economic recessions. This needs to be reminded to clients constantly, so that they do not make behavioral mistakes towards their life savings and goals.
Explaining Risk Management
Before discussing ways that we mitigate risk and protect our client’s capital, it’s important to have the same definition of risk management.
When we get in our car and drive to work, we’re taking a risk. Likewise, the act of not driving to work for the day would also assume the risk of not earning a day’s wage.
People typically assume risk to achieve an outcome. Generally, we’re willing to take more risk to achieve greater rewards, but less likely to take big risk that leads to moderate or low returning outcomes. As the risks we take are usually proportional to the benefits we’re looking to achieve, there are certain things we do in life to reduce our risk.
For example, when we have a job, we’ll likely drive the speed limit and obey traffic laws, to ensure that we get to work safely. We put these measures in place to limit our risk and achieve the outcome we desire.
But what if you’re told that being late to work again will lead to your termination? Well, in this case you might increase the level of risk you’re willing to assume, by speeding to work if you’re running behind.
Although there’s a greater risk of potentially getting into an automobile accident, you might think that the payoff of keeping your job is in your best interest. Therefore, you’ll likely take proportional risk in order to not lose your income and have job security.
Now, when it comes to our role as financial advisors, the risk that we manage for our clients are investment risks. Although we can never fully eliminate investment risks for our clients, we can ensure that they follow certain strategies that result in less investment loss when the next inevitable downturn or market correction occurs.
Investment Risks and Risk Mitigation
Generally, investment risk refers to the risk of our investments decreasing in value. Let’s face it, there are several challenges that our clients face while planning for years or decades of investing to achieve a specific goal. Thus, there will be several potential risks that your client will experience during different market cycles.
By identifying the ways in which your clients experience it, you are able to use strategies that both maximize their returns and limit downside. As financial advisors, managing risk and preserving wealth are the most significant parts of our role. Therefore, it is important to identify, monitor, and communicate those risks to our clients as we see changes in the financial markets.
This can sometimes be a struggle, as your client’s top priority at certain times might be to grow their assets, while you may prefer focusing on preserving wealth through risk management strategies. That’s why completing ongoing risk assessments and discussing risk management with your clients is invaluable. Especially when they bring it up in conversation. In general, clients will have a hard time understanding that what you’re doing is providing them with the best tools to have the best success over time, even when there’s an unconstrained market rally like we are in.
Of course, a good portfolio is designed to meet the client’s investment objective and also matches their risk profile. By using our PRISM software, an advisor could scientifically design and implement changes to the client’s overall portfolio.
A handy way to remind them is to send a risk tolerance questionnaire. StratiFi has a standardized 17 question PRISM Risk Tolerance Questionnaire for you to use with your clients.
What will your clients say as they read that the Nasdaq is at a new high, but their portfolio isn’t? They will think you haven’t done the job they paid you for, when the opposite is true. By having proper risk management in place, you’re preparing for the next market pullback, not trying to maximize the return.
If you only focus on maximizing returns for clients with high risk tolerance, without putting any risk management measures in place, your client could fail at both building and preserving wealth. Here’s a look at what an upside/downside capture would be, that you could show your client:
Although it’s possible to limit returns by implementing risk mitigation strategies, you also won’t be exposing your client’s investments to excessive risk. This is something that even an investor with a high-risk tolerance can appreciate during an S&P 500 bear market, or a black swan event for instance. If you need to visually show your client what this looks like, StratiFi has that available for you within the PRISM Rating.
So, how can you explain the importance of risk management to your clients? After determining each client’s risk tolerance, it’s time to explain which types of risk are most likely to impact your clients, before devising strategies to manage said risk.
Common and Uncommon Types of Risk
As you’re aware, there are several types of risk. There’s general market risk, inflation risk, opportunity risk, and several others. Here are four types of risk that you might not have discussed with your clients, regardless of their individual risk tolerance, but that you need to bring up so they know you are taking them into consideration with their portfolios.
You can get a breakdown on how StratiFi calculates these types of risks here.
Tail Event Risk
The first type of risk you’ll want to explain to your clients is the tail risk. This refers to the risk of an investment declining three standard deviations or more. Although rare, this occurs during large market crashes, like what we experienced in 2008, and during the pandemic.
The best way for your clients to reduce tail event risk, is by diversifying. Specifically, they’ll want to find investments that are inversely correlated to their most commonly held investments. We can help you with that.
Diversification Risk
The second type of risk to discuss with clients is diversification risk. It’s easy to assume that you’ve diversified your portfolio, only to be in for a shock when there’s a coordinated loss event. When stock markets are in freefall, correlations tend to increase, and even what you think is a properly diversified portfolio could turn into disaster. Knowing how your assets will move in advance of a bear market will help you decide what to put in it.
Concentrated Stock Risk
Third we have concentrated stock risk. In an environment where the largest corporations garner a lot of investor attention, it’s not uncommon for individuals to focus on a few well-known stocks.
You can fight this idiosyncratic risk by choosing a good mix of companies for your clients to invest in. As time goes on, be sure to rebalance their portfolios, so that they aren’t exposing themselves by holding a large percentage of their wealth in a few stocks.
Volatility Risk
Finally, there’s volatility risk. Usually, it is good to have volatility if we are trading for the short-term, however our clients are usually playing a long game. It is important to consider how volatile their investments are both individually and as a whole.
To combat volatility risk, you’ll want to help clients choose investment options that have moderate volatility, instead of chasing highly volatile investments with more significant risks. It might be boring to chase “average” profits, but it should be much safer when the next correction or bear market comes along.
In conclusion, as advisors we know that it is only a matter of when, not if, the next bear market occurs. It’s natural to experience corrections in a healthy market, so we should prepare our client’s portfolios for these events. By completing risk assessments and educating our clients, we can guide them to take steps that will protect their assets in any climate. Let’s use these strategies to help our clients build and maintain their wealth, while also mitigating their investment risk. They’ll benefit from these measures during bull markets and appreciate our work when the market takes a turn. Even if they are giving you passive aggressive comments during this market rally, make sure they know the work and science you put into their portfolios.