Risk, although not as bad as it often is perceived, can create fear and draw intense emotional reactions from clients. Helping your clients understand risk is important because the more risk they take, the greater their potential returns.

“It is absolutely crucial to have a serious conversation about risk with clients,” says Kevin Sullivan, vice president, portfolio manager and advisor with MacDougall, MacDougall & MacTier Inc. in Toronto. “Don’t just gloss it over.”

Clients have varying degrees of tolerance for risk, Sullivan adds, so the discussion must be personal.

There are two basic aspects to the risk discussion: risk tolerance and risk capacity. Risk tolerance is based on clients’ emotional make-up and reflects how much risk they are willing to take. Risk capacity is a more empirical measure of theamount of risk clients can take based their circumstances such as age, time to achieve their investment goal, income and net worth.

Here are five tips for helping your clients understand risk:

1. Relate risk to clients’ personal situation

For clients to achieve their investment objectives, two main factors come into play: the time they have to achieve their investment goal and the rate of return their investments must provide to achieve their goal. You also have to take into account their other assets and liabilities.

“You have to balance out all the factors to determine how much risk a client should take,” Sullivan says.

However, he adds, while clients might be psychologically motivated to take a higher level of risk, they typically overestimate their risk tolerance.

2. Demonstrate risk scenarios
Use illustrations to demonstrate various risk scenarios. Sullivan uses charts to illustrate the long-term returns of different asset classes. His aim is to show clients that although certain asset classes are riskier, as measured by standard deviation (a generally accepted measure of risk), they generate higher returns.

He then explains to clients: “Market fluctuations and volatility come with the turf; they have always occurred and always will.”

You also can show best- and worst-case scenarios by varying the asset mix in your illustrations.

3. Test clients’ understanding of risk
You can delve deep into clients’ true understanding of risk by presenting them with a variety of hypothetical scenarios. For example, if you frame a question about potential loss in percentage terms, he says, clients tend to overestimate their risk tolerance. However, if you ask the same question expressing losses in terms of dollars, you often will get a different answer.

For example, a client may say that he or she can tolerate a 20% loss on a $100,000 investment. But you often would get a different answer if you asked whether the client would be able to tolerate a loss of $20,000 on the same investment.

4. Talk about your process for managing risk
Discuss your risk-management process with clients. Sullivan, for example, explains how he uses a quantitative process to assess risk at the market, asset-class, sector, and individual security level. Show them how you construct a diversified portfolio to minimize losses.

5. Balance risk tolerance with risk capacity
Typically, a client with a high risk tolerance and a long time horizon may not have to take significant risk to achieve his or her investment goals. That’s because such a client would have time to ride out market fluctuations, Sullivan says. Conversely, a client with a low risk tolerance and a short time horizon may need to take more risk to achieve his or her goals, depending on his or her financial circumstances.

“The goal is to arrive at a happy medium,” Sullivan says, “so that your clients can sleep at night.”