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How Financial Advisors Talk About Risk

From longevity and inflation risk to worries about volatility, this is a good time for advisers and clients to discuss risk tolerance.
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As a financial adviser you likely think about risk in various ways on a regular basis. Your definition of risk may, however, differ from that of your clients. Especially with the recent COVID-19 related market downturn, it is important to discuss risk with your clients and that you have a clear understanding of how they view risk.

What does risk mean to your clients?

Many of your clients may not have experienced a market decline as swift and deep as what we’ve seen over the past several weeks. Your clients may be feeling a wide range of emotions, including fear in some cases. Any discussion of risk in this time period needs to start with understanding the emotions that your clients are feeling.

To most clients, risk means the risk of losing money. But there are other forms of risk to discuss with them as well.

Longevity Risk

Especially in a market downturn, many of your clients in or nearing retirement may want to pull way back on their allocation to stocks or to totally get out of equities. You need to remind your clients that the financial planning you’ve done with them assumes there will be periods like this in the stock market.

Further, it's important to reiterate to these clients that any moves to significantly reduce or eliminate their equity allocation could result in their coming up short in retirement. The risk of outliving their assets might be the biggest risk that any retiree faces today. With many of us living longer and the rising costs of healthcare in retirement, most retirees need a level of exposure to stocks in their portfolio.

Even for clients who may have a number of years to go until retirement, backing away too far from equities can leave them short of their retirement goals down the road. This can impact when and even if they ultimately retire. For younger clients feeling fearful this is an important conversation to have.

Inflation Risk

Related to the risk of running out of money is the risk that even a relatively low level of inflation can seriously erode a retiree’s purchasing power. A 3% level of inflation will cut a retiree’s purchasing power in half within a 24-year period. Inflation at this level is not far off of the historical averages since World War II.

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Further, many of the costs that are part of a retiree’s budget tend to rise faster than the general rate of inflation. A case in point is the cost of healthcare in general, including items like prescription medications in particular.

Combine this with the fact that cost-of-living adjustments on Social Security have been fairly low in recent years and need for a level of inflation protection becomes even more apparent. This should be part of the risk conversation with older clients who urge you to move them out of equities to any great extent.

Ask Questions

The best way to gauge your client’s feelings about risk is to ask them. You know your clients as the individuals that they are so the types of questions will vary a bit by client. Some examples might include:

How do you feel about the recent drop in the stock market? Clearly no client is going to be happy, but the answers you get will likely vary quite a bit. Some will shrug and say that this is part of being a long-term investor. Others will exhibit greater levels of risk. How your clients respond can help your frame a discussion about risk.

Has your situation changed in the wake of the COVID-19 pandemic? What you are trying to gauge is the client’s employment situation has been adversely impacted by the pandemic or if they own a business, how has it been impacted? If their income stream has been diminished by this situation, this might limit their ability and willingness to take on as much investment risk as they had in the past.

How does each spouse feel about investment risk? If your client is a married couple, be sure that you discuss their feelings about investment risk with each client to ensure that your investment advice is geared towards the risk tolerance of each of them?

While you’ve likely discussed risk with clients in the past, there really hasn’t been a significant market downturn since the bottom of the market in the wake of the financial crisis in March of 2009. It’s important for financial advisers to really listen to their client’s fears and concerns during this period of market volatility and declines.

Clients who may have seemed relatively unconcerned with investment risk in prior years may be having a change of heart based on the declines they are seeing in their portfolios currently. It's important for advisers to ensure that they truly understand their client’s feelings about investment risk during these trying times.