It's best for advisors to have this conversation in blunt language. How blunt? FinMason's Wakeman evokes horror stories from the Great Depression.
"You need to ask your clients, 'Would you hang yourself in the closet if the market crashed and you lost 35 percent?'" If the client says yes, then it's up to the advisor to help them design a portfolio that would lose less in that scenario, Wakeman said. He added, "It's the client taking the risk, so they are entitled to know the risk they are taking, and there is no better way to talk about it except in a crash scenario."
The less math-based the conversation, the better.
"If you say, 'Over the next six months, we think there is a 95 percent chance that you won't lose more than 17 percent,' that's a legitimate risk metric from a quantitative finance standpoint, but it's not a good way to explain risk to people with no financial training," Wakeman said.
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John Ndege, CEO of the risk-tolerance software provider Pocket Risk, said the time is ripe for advisors to be having this talk with clients. "The only time the markets have seen such a bull run as there has been since 2009 was right before the dot-com crash and before the Depression," Ndege said. "You need to ask them how secure their job is and do they have enough cash saved for a rainy day.
"You should also check in to see if a client will be able to stomach a collapse and, if there is some kind of recession or downturn, are they ready for it?"
Ndege focuses on two kinds of risk analysis: risk tolerance and risk capacity.
Risk tolerance involves having a thorough understanding of someone's psychological risk tolerance and how much of a drop in their portfolio they can handle psychologically before they want to sell. Risk capacity is more objective. It looks at how much the person has saved, the security of their income and whether they will need to withdraw assets any time soon.
The fine line is to have this conversation without scaring the clients.