Among the most important things that good advisors bring is the ability to help clients make the right trade-off between risk and return ... and also to help clients understand the critical impact of the time frame over which they hold investments on the volatility they experience.

One of the most important conversations these days is about the amount of risk that clients should take in their portfolios.

This month's column in Investment Executive outlines three steps to make that conversation an effective one.

Step One: Talk about long-term returns

You could start by reminding clients of after-inflation returns for different investments for the 84 years from 1926 (as far back as we have really good data) to the end of 2009.

This compares large cap US stocks to intermediate, 5 year Government bonds and T bills. Note that you should frame this in terms of real, after- inflation returns - what really matters to clients investing for retirement.

Note that after inflation, stocks have returned three times bonds and ten times T bills.

Then translate that return into the real return on client portfolios.

For someone investing $100,000 in stocks, the after-inflation appreciation of $259,000 is almost five times that in bonds and almost twenty times the gain in T Bills, which just barely beat inflation.

                                             Average real return      $100,000 compounded at this rate                                                (after inflation)              for 20 years - in today's dollars       

                                                                                       Ending Balance       Appreciation

U.S. large cap stocks                      6.60%                              $359,041            $259,041     

5 year Government bonds               2.26%                              $156,356            $56,356

T bills                                            0.64%                              $113,609            $13,609     

Step Two: The odds of losing money

Next, talk to clients about the historical experience of losing money in stocks after inflation, based on different holding periods.

Historically, holding stocks meant that after inflation you lost money about one in three years.

Looking at three year periods reduces the chances of losing stocks to about one in four.

In ten year timeframes, investors lost money 12% of the time - based on the experience since 1926; you have to go out to twenty years to completely eliminate the chances of losing money in stocks.

                                                            U.S. large cap stocks: Real returns

                                                Winning years             Losing years    % of the time lost money

            One year                                  57                        27                            32%                                        

            Three years                              63                        19                            23%

            Ten years                                 66                          9                           12%

            Fifteen years                            66                         4                              6%

            Twenty years                           65                         0                               0%

Step Three: Communicate this visually

Finally, portray the nature of the experience in a way that investors can relate to.

To do that, I worked with Michael Nairne and his team at Tacita Capital to convert data from Morningstar's Encorr database  using the Ibbotson SBBI Large Company Stock index into a number of charts, showing returns over 1, 3, 10, 15 and 20 years. These charts can be found at the end of this article.

The first chart shows 1 year returns - it has extreme spikes; if this was all that investing in stocks entailed, most investors would bail out right there.

The next chart shows rolling 3 year returns, still a bit of a roller coaster, but less so.

The third 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 many clients would like but also a level that most can live with.

You can go on to show these charts for 15 and 20 years, which show volatility at a progressively lower level - but you risk losing buy in from clients for whom thinking even ten years out is a stretch.

How this conversation might go

Here's how this conversation might go.

Start off by reminding clients that over the long run and after inflation, U.S. stocks have earned over 6% annually, even after the disastrous stock market events of 2008 and early 2009.

Then, point out the dramatic difference on long term portfolios between holding stocks, bonds and cash.

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 periodically you will lose more than 20% in a calendar year".

Notice that you don't say "You might lose 20%", you say "You WILL lose 20%."

And you could go on to say: 'And twice, these 20% declines occurred two years in a row."

Explain further: "We know this because in the 84 years since 1926, stocks have lost 20% or more eight times after inflation - so about one in ten years.

Three of those were in the 1930s, then in 1946, in 1973 and 1974 and most recently in 2002 and 2008″.

 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 ... and then ten years."

And depending on the client, you could also show them the fifteen and twenty year charts.

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'll 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 time frame of ten years or more, 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.

US Large Company stock returns after inflation, 1926 to 2009

  Source: Ibbotson SBBI Large Company Stock index, Morningstar Encorr database   Average=_____