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The Short Answer

Is Your Mutual Fund Taking Too Much Risk?

The subprime mess has hurt lately, but keep the big picture in mind, too.

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In December, I took another look at how the subprime-mortgage mess was affecting various types of mutual funds and how it's likely to affect them in the future. Such blowups highlight the facts that investing comes with risks and that some investments are riskier than others. Identifying those risks, and figuring out how much you're willing to tolerate, is one of the most important aspects of long-term investing.

Unfortunately, there's no single definition of risk that works for everybody, but there are some key measures that will usually give you a good approximation. They're not perfect--there are often hidden risks lurking--but they're certainly better than guesswork. Here are some of the most useful ways to look at mutual fund risk.

Backward-Looking Risk Measures
The world of finance is replete with measures that try to gauge how risky an investment has been in the past. In this context, risk is often equated with volatility, and the most common way to measure the volatility of a mutual fund (or any portfolio) is standard deviation. As Morningstar calculates it, this measures how widely the fund's monthly returns have varied over some period of time, usually three, five, or 10 years. If monthly returns have been very consistent, the standard deviation will be low, while if they have been all over the map, the standard deviation will be high. (You can find more about the details of our methodology in this document, and you can find any fund's three-year standard deviation on its Risk Measures page on Morningstar.com.)

David Kathman does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.