Recently, I was listening to "Biznet", 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 look at, 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".

As I reflect on some of the research I've conducted 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 - that 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 and the like. (When I've shown investors returns 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 at an intellectual level often get sucked into chasing "safer" investments, seeking the holy grail of higher returns without higher risk.

Among the most important things that good advisors bring is the ability to help clients make the tradeoffs 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 back on how to help clients understand the reality of investing in stocks. This is particularly timely in light of the ugly markets since late January - with no indication that the volatility we've seen will end anytime soon.

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.


For this research, I developed four charts showing returns in U.S. large cap stocks going back to 1926, based on data from Ibbotson Associates (since acquired by Morningstar). The first chart shows 1 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 3 and 5 year average returns, still a bit of a roller coaster, but less so.

The last chart shows rolling average returns for 10 years - by the time you get to 10 years, you see a level of volatility that is still more than clients would like but also a level that most can live with. (You can go on to show this chart for 15 and 20 years, which shows volatility at a progressively lower level - but you risk losing buy in from clients for whom thinking even ten 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% over what they got on bonds. Then translate this into what it has meant to investors; based on long term performance, twenty years out $1,000 invested in stocks has yielded gains of $6,200 - that same $1000 in bonds generated profits of $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 ten 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 81 years since 1926, stocks have lost 20% or more five times, three times in the 1930s, then in 1974 and most recently in 2002". Then show them the chart with 1 year returns - and spend some time talking about it.

Continue on: "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 get cut off.

"Here's what returns look like over a three year time frame ... five years ... and then ten years."

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

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 investors with a ten-year time frame, history truly is on their side.

Consider using charts such as these to back that story up - pictures truly do 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 from the PowerPoint slides section on this site.) The time you spend to craft and deliver this message could be one of the better investments you'll make.