Stock mutual funds use a number of different terms to describe their investing characteristics. Flip through a pile of fund prospectuses and you'll see terms such as "equity income," "growth and income," "growth," "aggressive growth," and so on.

The problem is these are merely general statements of theoretical goals and strategies; a fund's actual holdings have tremendous room for variance while staying within those broad guidelines. So, to provide greater insight into the degree of risk a stock fund carries, SMI uses a different approach for classifying funds. Ours is based on the actual investment strategy currently being used by the fund manager and reflected in the portfolio holdings. This involves identifying two elements.

First, we want to know the size of the companies (as measured by their current market value) the fund manager is investing in. Larger companies, such as those in the S&P 500 Composite Stock Index, are usually stronger in terms of market penetration and financial strength. Consequently, they typically are lower-risk in nature. While their earnings may be temporarily affected by competitive pressures, technological developments, or a recession, large companies are expected to survive and prosper.

Smaller companies, on the other hand, carry higher risk because they are more easily devastated by such setbacks. However, they have the potential to grow to 10, 20, or 50 times their present size. The time to "get in on the ground floor" is when they're still relatively small.

The remaining size category is "midcaps," companies that are medium in size, falling somewhere between large and small.

The second element that affects a fund's risk profile is the portfolio manager's investing philosophy, or "style." Although many variations exist, two approaches dominate. First, there is the value camp, which emphasizes how much you're getting for your investment dollar. A "value" manager primarily considers a company's assets, earnings, and dividends in arriving at an assessment of its stock's intrinsic value at present. Such managers prefer to bargain-hunt, and often end up buying unglamorous, unappreciated companies (because that's where the bargains are).

The other style of stock investing is the growth camp. Fund managers with this strategy act on future expectations. When measured in terms of the company's current earnings and dividends, the stock may appear expensive at present, but if the company can achieve its potential, today's share price can look like a steal a few years from now.

Thankfully, we don't have to analyze the thousands of mutual funds ourselves. Morningstar is the industry heavyweight in monitoring mutual fund performance and risk characteristics. They classify funds based on whether they invest in small companies, mid-sized companies, or large companies. They also categorize funds based on the value vs. growth management-style distinction, but also add a "blend" option for those funds that don't fit neatly into one style or the other. By combining these three size possibilities with the three style options, Morningstar is able to classify every diversified stock fund into one of nine risk categories.

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The Morningstar system is a huge help in bringing clarity to the risks posed by the various kinds of funds. However, because SMI is all about trying to simplify investing for the average investor, we have long felt that nine categories was too many for our purposes. So, we simplified the system to make it easier for our readers to understand fund risk. We assign every stock fund to either a "small" or "large" category, and either a "value" or "growth" category. We do this by combining most of the "mid" funds into our small-company categories, and most of the "blend" funds into our value categories.

The chart above helps explain why we categorize the "mid" and "blend" funds as we do. It plots the risk and return for each of the nine categories using Morningstar's latest data.

For example, small-company/value-oriented funds as a group have returned 8.5% annually over the past 15 years with a standard deviation of 19.2. (Standard deviation is a measure of volatility that is often used as a gauge of risk.) It quickly becomes apparent that the mid-cap funds behave more like the small-company funds than they do the large ones (see how close together the mid/growth and small/growth funds are versus large/growth). And while less stark and not highlighted on the chart, the blended funds are more similar to value funds than growth funds.

While this information is useful primarily in categorizing mutual funds within SMI's strategies, it can also be helpful to those who own individual stocks. If you own one or more individual stocks, you can simply visit Morningstar.com, type in the stock's ticker symbol and scroll down the page to find the "Stock Style" they assign to the company.

As with mutual funds, Morningstar uses nine risk categories, whereas SMI uses only four. However, the table at right will enable you to quickly assign most stocks to the appropriate SMI risk category. While individual stocks tend to be a bit riskier than mutual funds due to the inherent lack of diversification in owning a single company, at least this will help you understand where each stock fits within the SMI risk ladder, so you can be sure your overall category allocations are roughly in line with our published recommendations.