Recently, I was listening to the Business Network, an early-morning CBC Radio program in which the host was interviewing one of Canada’s mutual fund gurus. When the host asked what funds he should consider, the guest sensibly answered that any recommendation would start with the host’s goals, to which the host replied: “My goals are simple — I want to make a good return without risking my money.”

Over the years, when conducting research with affluent Canadians, I have regularly been surprised by the difficulty that even fairly sophisticated investors have in grasping the basic “no free lunch” truth about investing: you cannot get returns above GIC levels without incurring risk.

The good news is that most investors today understand this when it comes to emerging markets. When I’ve shown investors returns on investments in China and India, a common response is: “The manager must have taken a lot of risk.” The bad news is that even investors who understand this on an intellectual level often chase “safer” investments, seeking the holy grail of higher returns without higher risk.

An important quality good advisors bring to their relationships with clients is the ability to help clients make the trade-offs between risk and return that are right for them. As I reflected on that CBC interview, I was reminded of some research I’d done a few years ago on how to help clients understand the reality of investing in stocks. This is particularly timely in light of recent ugly markets and with no indication that the volatility will end any time soon.

For the research, we tested all the familiar analogies, such as not missing the best days and keeping your eye on the horizon when in rough seas, and then tried a different tack entirely.

I developed four charts showing returns of U.S. large-cap stocks going back to 1926, based on data from Ibbotson Associates Inc. , now a subsidiary of Morningstar Inc. The first chart shows one-year returns; it has extreme spikes. If this was what investing in stocks entailed, most investors would bail out right there.

The next two charts show rolling three- and five-year average returns, respectively. It’s still a bit of a rollercoaster, but less so.

The fourth chart shows rolling average returns for 10 years. By the time you get to 10 years, volatility has leveled out. It is still more than most clients would like, but it is also a level with which most can live. You could go on to show this chart for 15 and 20 years, with volatility appearing progressively lower, but then you would risk losing buy-in from clients for whom thinking even 10 years out is a stretch.

When talking to clients, start off by reminding them that over the long run stocks have earned almost twice what investors could get on GICs and more than 50% more than bonds. Then translate this into what it means to investors: based on long-term performance, $1,000 invested in stocks over 20 years has yielded gains of $6,200. That same $1,000 in bonds generated $2,150.

Go on to say: “The downside is that if you invest in stocks, we know that you’ll lose money about three in 10 years and, at some point, you will lose at least 20% in a calendar year.”

Notice that you don’t say: “You might lose 20%.” You say: “You will lose 20%.”

Explain further: “We know this because in the 82 years since 1926, stocks have lost 20% or more five times: three times in the 1930s, again in 1974 and most recently in 2002.” Then show them the chart with one-year returns — and spend some time talking about it.

Then you continue: “The good news is that the longer your holding period, the less you have to worry about this. The extreme ups and downs disappear and the tops and the bottoms on returns are cut off.

“Here’s what returns look like over a three-year, five-year and then 10-year time frame.”

This works best if you flip through the slides on your computer in fairly rapid sequence, so it’s almost like slow-motion animation. When you’ve finished, you can have a conversation with clients about their time frame, risk tolerance and ability to sleep at night.

Our objective in talking to clients should be to explain things in a way that is not just persuasive and easy to understand — but also to communicate in a way that they will remember. To do that, we have to connect at both a rational and an emotional level. Only by making an emotional connection will our message really stick. For advisors who want their messages to penetrate, find your own set of words to show that, for clients with a 10-year time frame, history is on their side.

@page_break@Consider using charts such as these to back that story up. Pictures communicate in a way that words or numbers alone never will. These charts and others showing a similar analysis for small company stocks and corporate bonds can be downloaded by clicking on the link to my blog below.

The time you spend to craft and deliver this message could be one of the better investments you’ll make. IE

Dan Richards is president of Toronto-based Strategic Imperatives Ltd. He can be
reached at richards@getkeepclients.com. For other columns in this series, visit www.investmentexecutive.com.