Having a good understanding of your clients’ tolerance for risk is key to managing their expectations and maintaining good relationships with them. Otherwise, you could find yourself at crossroads with some clients if their investment returns do not meet their expectations.

“People often over-estimate their level of risk tolerance,” says George Hartman, CEO of Market Logics Inc. in Toronto. “Only when their investments fail do you find out their true risk tolerance.”

John Nardi, financial advisor with Edward Jones in Mississauga, Ont., puts it this way: “Everyone is willing to take on more risk until they lose money.”

Here are a few approaches to managing your clients’ expectations by understanding their risk tolerance:

> Know clients, inside and out
It is important to have an indepth understanding of your clients’ personal financial circumstances.

“Ask questions,” Nardi says. “Listen to what they’re saying.”

For instance, Nardi adds, you must know your clients’ goals and expectations, and what they are willing to give up in terms of losses, he adds.

Prem Malik, chartered accountant and financial advisor with Queensbury Securities Inc. in Toronto, says many factors come into play in getting to know your clients. They include the client’s total financial assets and liabilities; age; time horizon; level of financial knowledge; and risk orientation.

> Determine clients’ tolerance for risk
Hartman recommends using a risk profile tool — such as a risk questionnaire — in combination with practical and real-life examples to gauge clients’ ability to handle risk. In a real-life inquiry, you might ask the client how he or she would react to losing 40% of his or her portfolio.

While taking risks is “generally socially acceptable,” Hartman says, you may find that many clients can tolerate less risk than they say they can.

> Know your products
You must have sound knowledge of the products you offer and how they can fit the unique needs of each of your clients.

“Provide different illustrations that show how the portfolio you recommend can meet their needs,” Malik says.

Show your clients how risk can be counter-balanced in different scenarios, Hartman says, using various asset-allocation strategies.

> Educate your clients
Explain all possible risks, Nardi says, by using the different client-education strategies available. They include: describing best- and worst-case scenarios; explaining to your clients how they can achieve different rates of return by varying risk; and illustrating the impact of market volatility on various portfolios.

Your goal, Nardi says, is to help your clients understand the many scenarios through which their needs can be met.

> Get client consent
Be sure to obtain confirmation from clients that they have consented to your recommendations, Malik says, and that they have accepted the associated risks.

Consent implies a “joint decision,” Nardi says.

“At the very least,” Hartman says, “you need your client to sign an investment policy statement.”