How to Gauge a Morningstar Risk

In order to give investors an idea about the variation in a fund's month to month return, Morningstar developed a system known as the Morningstar risk. It basically tells investors how frequently a given fund loses money compared to a relatively risk-free venture, such as the U.S. government T-bill. It's a fantastic tool to have when choosing funds to buy, as well as monitoring existing funds in your portfolio. All investors can benefit by learning more about how to gauge a Morningstar risk.

Instructions

Difficulty: Challenging

Things You’ll Need:

• Morningstar risk rating
• Mutual fund

Gauge a Morningstar Risk

1. Analyze the theory behind the Morningstar risk rating. The average investor is risk-adverse, a situation that signals the need for a mathematically based risk-rating system. Risk is estimated by computing a risk penalty for each fund.
2. Understand how the Morningstar risk rating works. The risk rating is developed by taking the result of the difference between the raw return of the fund and its risk-adjusted return.
3. Find out what category your fund is in. Morningstar divides all funds into distinct categories to avoid confusion and comparisons.
4. Learn how the risk system is ranked. All funds are ranked from high to low, based on their risk penalties. The wider the month-to-month variation is for a given fund, the higher its risk factor.
5. Figure out where your fund lies. The top 10 percent of funds is considered high risk by Morningstar, with the next 22.5 percent considered to be above average risk. The middle 35 percent is called average and the bottom 22.5 percent is below average. Only the bottom 10 percent of funds are given the designation of being low risk.
6. Gauge your risk. If your fund is rated average and above, that's a clear indicator that it is expected to come with little serious risk.

Tips & Warnings

• Keep in mind that Morningstar risk calculations have an emphasis on downward variation.
• The risk-adjusted return is based on the economic theory of expected utility. Simply put, this states that investors are more concerned about unexpected financial loss than with the potential of making large amounts of money.
• The less variation there is in a fund from month to month, the lower the risk rating. Conversely, the more the variation, the higher the risk rating.
• The Morningstar risk system is relative, meaning it is only applicable to funds in the same category. Don't try to compare funds from two different categories.