Helping clients embrace risk intelligently to achieve their financial goals

It’s impossible to avoid risk in our everyday lives. From driving on the highway, eating in restaurants, and flying in planes, to attending parades, sporting events, and concerts, most of us make calculated assumptions about which risks are safe to assume and which ones are reckless.

When it comes to our money, however, risk plays all kinds of games with our emotions and often triggers our fight-or-flight response. Unless your clients are willing to embrace some risk in their investments, there’s a good chance they won’t achieve high enough returns to reach their retirement and life goals.

If you’re thinking about adding investment advisory services to your accounting practice, just know that being crystal clear about each client’s unique tolerance for risk is the first step toward getting them invested properly.

What is risk tolerance?

Aaron Klein, co-founder of Nitrogen software for financial advisors, explained in my new book that risk tolerance is a person’s ability and willingness to endure market fluctuations and potential losses without abandoning their investment plan.

“It’s a complex interplay between their financial goals, investment timelines, and personal experiences,” said Klein. It comes down to each client’s psychological comfort with uncertainty along with, “no two people have the same tolerance for risk, regardless of their age, gender, occupation or financial upbringing.”

That’s a huge consideration. Many of you considering offering financial services to your practices may assume that older clients are always risk averse and that younger clients are always risk tolerant. That’s a mistake. As you get to know your clients, you’ll find plenty of 20-somethings who are highly risk averse and plenty of 70-somethings who are aggressive investors. So it’s dangerous to assign cookie-cutter portfolios to clients based solely on their age, gender, or other demographics. If you do, your biases can lead to faulty portfolio construction.

Likewise, many clients will tell you in initial meetings that they have a decent tolerance for risk because it sounds like the right thing to say. But when the markets get volatile and the doom-and-gloom headlines start flying, they’re really not as risk tolerant as they think. You can bring tremendous value by helping them see how far their portfolio can fall during a downturn before they capitulate and make a fear-bound decision such as selling all their stocks and moving into cash or Treasury bonds.

Only then can you help clients determine how much risk they can reasonably stomach in order to reach their financial and life goals—while sleeping well at night. As an accomplished accountant, you are in many ways a risk mitigation expert, so you have a built-in trust-level with clients when it comes to handling investment risk. Even if there’s a bad year in the stock or bond markets like we had in 2022, do not feel that, alone, is going to cause you to lose a client’s business. It’s all about reframing client expectations.

How to reframe client expectations

If the risk conversation isn’t adequately communicated, a market downturn can cause your clients to flood your offices with calls like these: “Are we going to be OK or should we move to cash?” Meanwhile, during an unexpected bull market like we saw in 2023, those same clients call in asking: “Why am I not beating the market?”

That’s where a proper risk conversation comes into play. According to Klein, clients just want to know what’s normal for their portfolio.

“That’s where it’s important to frame the conversation around a six-month 95% range,” said Klein. “That range is the likely span of gains or losses a portfolio might experience over a six-month period within a 95% confidence interval,” or within two standard deviations of the mean in statistical parlance.

For example, over the last 30 years, the Stocks/Bonds 60/40 Portfolio achieved an 8.05% compound annual return with a 9.63% standard deviation. In other words, you can tell clients that given their asset allocation and risk parameters, 95% of the time their 60/40 portfolio is expected to return 8% on average (plus or minus 19.25%). As a result, 95% of their portfolio will return between +27.25% and -11.25%. Going back to 1986, there was only one year in which the 60/40 portfolio met or exceeded +27% (1993) and only four times when it returned less than -11% (1990, 2002, 2008, 2022, see chart below). Source: Backtest by Curvo

The 5% left over is a statistical standard of downside risk that can’t be quantified and includes Black Swans, unforeseeable market events, wars, or a natural disaster, and represents a devastating loss for the client. However after thorough testing in different market environments, less than 1% of portfolios have actually dipped into that 5% devastation range.

The 5% outlier range is something we can’t control, but the 95% interval is something we can control by setting realistic expectations for clients. When you do, they’re more likely to hang tough when the markets are volatile.

Control risk vs. beat the market

Whether they know it, Klein said every investor has a “sweet spot” between how much they want to earn from their investments and how much risk they’re willing to bear to get there. Financial theorists call this the “efficient frontier,” and that’s where your clients should be spending their time. But that frontier varies for each client. Klein’s firm takes the efficient frontier concept a step further by assigning a specific “Risk Number” to each client, on a scale of 1-100, to show them precisely how much risk they can handle.

For instance, you can show a risk-averse client that the S&P 500 has a Risk Number of 78. If their own Risk Number is 52, then their portfolio can’t be expected to return as much as the overall market in a bull year. But in a down year, it won’t lose as much. That’s the tradeoff for having more peace of mind when markets are volatile.

While many of your clients will tune out when you try to explain standard deviations, efficient frontier, and asset allocation, they can all relate to a Risk Number when it’s on a convenient 1-100 scale. Taking complex topics and simplifying them for clients in terms they can understand is often more valuable for clients than the actual returns you generate for them.

Be your clients’ advisor

By getting to know your clients’ values, needs and goals, you can help them embrace risk intelligently rather than running away from it. You’ll add tremendous value by ensuring they achieve their financial and life goals. You’ll probably even sleep better at night.

DISCLAIMER: https://www.arrowrootfamilyoffice.com/disclaimer/