Open any financial magazine and youre likely to see ads from mutual fund companiesincluding the mutual fund ratings on their funds. Are these ratings useful? Do they help you locate the best mutual funds? Or can they actually be harmful when youre deciding which mutual fund to buy?

First, it helps to understand how these ratings are determined. While many companies offer mutual fund ratings companies like Lipper, TheStreet.com, U. S. News, Business Week, and Bloomberg, among others by far the most popular company providing mutual fund ratings is Morningstar.

The Morningstar ratings are the ratings youll see in all those mutual fund ads in the financial magazines Average 4 star rating from Morningstar or some such statement. So how do they come up with their ratings?

Morningstar attempts to evaluate both return and risk while comparing only similar funds, or mutual funds that are investing in the same sector of the market. This is so you dont compare a bond fund to an international stock fund, for example.  This is a key point to remember since a 4 star bond fund is not necessarily better than a 3 star large cap growth stock fund when it comes to your portfolio.

Also, the ratings are based on different time-periods: the trailing 3-year, trailing 5-year, and trailing 10-year periods. After the ratings are calculated, then the stars are assigned based on what percentile the mutual fund falls into. For example, the top 10% get a 5 star rating.

The Problem With Mutual Fund Ratings TMI!

Morningstar now lists 70 different categories for which they calculate ratings (Of course, for example, if Municipal Bonds dont fit in your plan, you can quickly eliminate 16 of those categories). This is a TREMENDOUS amount of information to sift through, and the process can not only be daunting, but extremely confusing.

The fact is that MOST people need only a very few investments to have a balanced, diversified portfolio, but the tremendous number of categories of mutual funds and all the mutual fund ratings from ALL the different sources (including Morningstar) can make your head spin! And human nature is to worry about missing out and not getting the best mutual fund.

But dont forget, even the best mutual fund in any particular category can still be a BIG loser. Just look at the last major market downturn in 2008.  You would have been hard pressed to find ANY stock fund with positive returns over the trailing 3-year period at the end of 2008, but the top 10% of those stock funds STILL received a 5 Star rating from Morningstar just because they were in the top 10% after the rating process. Yes, they were LOSERS (and shareholders lost money), but they still got the 5 star rating.

The moral of the story? Dont put too much emphasis on mutual fund ratings no matter what the source since there is much more than meets the eye. The tremendous number of funds makes the analysis almost overwhelming, and the fact isyou may end up pulling out your hair before you can make a decision.

Find a simple approach, have a plan that you understand and can follow, and remember this rule, especially when it comes to mutual fund ratings:

If you dont know, dont go!