Morningstar Risk score describes the variation in a fund's month-to-month returns. But unlike standard deviation, which treats upside and downside variability equally, the risk score places greater emphasis on downward variation, or losses.
The theoretical foundation for Morningstar Risk (and Morningstar's risk-adjusted return measure, also called the star rating) is relatively straightforward: The typical investor is risk-averse. Morningstar adjusts for risk by calculating a risk penalty for each fund based on that risk aversion. The risk penalty is the difference between a fund's raw return and its risk-adjusted return based on "expected utility theory," a commonly used method of economic analysis. Although the math is complex, the assumption is that investors prefer higher returns to lower returns, and—more importantly—prefer a more certain outcome to a less certain outcome. In other words, investors are willing to forego a small portion of a fund's expected return in exchange for greater certainty. Essentially, the theory rests on the assumption that investors are more concerned about a probable loss than an unexpectedly high gain.
Like beta, Morningstar's risk score is a relative measure. It compares the risk of funds in each Morningstar category. For example, a fund in the large-cap growth category is compared only with other funds in the same category. Likewise, a municipal-national short-term fund is compared only with offerings in the same category. This apples-to-apples comparison allows investors to evaluate the historical risk of funds that are likely to be considered for the same role in a broader portfolio.
Within each category, we rank each fund's risk penalty—the difference between its raw and risk-adjusted returns—from highest to lowest. A fund with greater variation in its month-to-month returns would be assessed a larger penalty than a fund with lesser variation. The level of risk is assigned based on the ranking for funds in the category: The top 10% of funds are High risk, the next 22.5% are Above Average risk, the middle 35% are Average risk, the next 22.5% are Below Average risk, and the bottom 10% are Low risk.
When using Morningstar Risk, remember that we set a fund's score based on its risk level relative to its category peers. You can't compare the Morningstar Risk score of funds from different categories, as you can their standard deviations. For example, an intermediate-term bond fund with High Morningstar Risk may be more volatile than other intermediate-term bond funds, but it could be—and, due to the nature of stock funds, probably is—less risky than a small-cap value fund with Below Average Morningstar Risk.
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