Morningstar Advisor - February/March 2009 - 9

Letter from the Editor Getting a Handle on Risk This issue marks the beginning of our new publishing cycle. You will now receive the magazine every other month, instead of quarterly. It’s fortuitous that our more-frequent schedule coincides with a financial crisis that deepens by the day. We’ll be able to give you the timely investing information you need to make critical decisions during a period when the market is taking more dramatic twists and turns than it has since the Great Depression. At the same time, we can continue to offer the careful perspective that comes from being tied to a more-deliberate schedule. The lead article in this issue’s Spotlight section (page 26) is a case in point. Last fall, Morningstar quantitative researcher Paul D. Kaplan heard the hyperbole coming from Washington and the mainstream media about the unfolding crisis and decided to look at the distribution of market returns over the past 80-plus years. He found that what was being billed as an extremely rare event was, in fact, not all that rare. To Kaplan, the big issue was investors’ perception of risk; they forgot that they could lose big in the markets. For this, he lays partial blame on the standard risk models in wide use today. Kaplan argues that they greatly underestimate the risks investors face. To get a better handle on the subject of risk models, we went to the source. For the Morningstar Conversation (page 40), we invited Benoit Mandelbrot, one of the creators of a mathematical model that does a better job of capturing the wide distribution of asset returns, to discuss the crisis with economists Roger Ibbotson, the founder of Ibbotson Associates, and George Cooper, who’s written an impressive new book on financial crises. Kaplan moderates the discussion. Mandelbrot, a renowned mathematician, has been knocking on economists’ doors for decades, hoping to get his thinking on risk heard. His work has been largely ignored, until now. As investors search for new ways to analyze risk, they are rediscovering Mandelbrot’s work. We dive deeper into the risk problem. Mutual fund analyst Arijit Dutta goes back in time and traces the risk measures of a handful of funds that surprisingly have performed poorly during the meltdown (page 34). Dutta wanted to see if the measures were alerting shareholders to the impending doom. They didn’t, he found. Only a close examination of the securities these funds were holding would have revealed the danger they were in. Which leads us to a point Don Phillips makes in his Phillips’ Curve column (page 80), and one Ibbotson mentions in the Morningstar Conversation. No risk model and measure will ever have the ability to capture or foretell every extreme event. But that doesn’t mean they have no use. Like the star rating, they’re just one piece of the portfolio-construction puzzle and should be used in tandem with other types of analysis. I’m eager to hear your thoughts on the matter. Please e-mail your comments to magazine_editor@morningstar.com. Jerry Kerns MorningstarAdvisor.com 9

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Morningstar Advisor - February/March 2009

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