Dear Member, Welcome to the latest quarterly newsletter from Morningstar Associates, the provider of Morningstar Online, a service selected by your retirement plan or employer to provide you with investment education, research, and retirement planning resources. If you are currently receiving the newsletter and wish to unsubscribe, follow the instructions at the bottom.   How Risky of an Investor Are You? Your capacity to assume risk—not your risk tolerance level—should drive the amount of stocks to include in your portfolio.   The extreme market volatility that ate into everyone's retirement savings last year has convinced many investors to reevaluate their appetite for risk. The problem, though, is that many investors who took a beating last year may be inclined to take a more conservative approach moving forward. That, however, can be as bad as assuming too much risk in your portfolio. Risk Isn't Bad Basically, for most investors, the percentage of your account balance allocated to stocks determines your risk level. The more you have allocated to stocks, the riskier your strategy. That's because stocks can be extremely volatile, meaning their value can rise and fall—sometimes significantly—from one day to the next, or even within a single day. Sometimes those ups and downs can be mild hiccups; sometimes they can be violent shifts. But stocks are an essential ingredient needed for long-term growth. The key is figuring out just how much of this ingredient you need based on your capacity to assume risk. If you are young and have many more decades until you plan to retire, your risk capacity is high and as a result you can afford to have a lot of stocks (most target-date funds designed for those in their 20s allocate between 70% to 90% to stocks). If the market tanks—like it did last year—you have decades to recoup your losses and potentially grow your account. In addition, young investors need stocks to jump-start their retirement savings and to take advantage of compound interest (see sidebar, "Retirement 101: Compound Interest"). What you should avoid as a young investor is being too conservative with your investments—even if the recent market turmoil left your stomach in knots. That's because your long-term focus should be on achieving your retirement goals. Without enough stocks in your portfolio, you run the risk of falling short—sometimes way short—of those goals. And that risk should outweigh any fear of a transitory market downturn. "We see many young investors who are too conservatively allocated," says Hal Ratner, an asset allocation strategist at Morningstar Associates. "Your 20s and 30s are the time when you can take the most risk because you have time on your side. In this case, not having enough stocks is worse than having too much."     Protecting Your Assets The risk of losing money in the short-term, however, is a bigger problem for those entering the home-stretch of retirement. Investors in their 50s or 60s can't afford to lose money because they generally don't have the time to recoup their losses. As a result, they have a much lower capacity for risk than someone in their 20s. If you are closing in on retirement, you should start ratcheting down your allocations to stocks and start increasing your allocations to bonds and cash (target-date funds designed for those in their mid-50s generally have about 45% to 60% in stocks). Some of the more heartbreaking stories coming out of the 2008 downturn were those of people who were on the verge of retirement but lost a significant portion of their retirement savings because their portfolios were still heavily laden with stocks. Many of them are having to make plans to continue working. "The downturn took its toll on all investors, but especially those on the cusp of retirement" Ratner says. "Many were far too aggressively allocated based on their time horizons to retirement. The lesson learned is that you need to adjust your allocations as you age." If you're close to retirement, though, you shouldn't dump stocks altogether. Since your retirement could last 20 to 30 years, you will still need to position your portfolio for some growth to reduce the risk of running out of money. In addition, you need some stocks to counterbalance inflation, which slowly erodes your savings over time. That said, you probably should be a little more selective with your equity investments. You might want to avoid, for example, loading up on emerging markets and small-cap stocks as they tend to be far more risky and volatile than large-cap stocks. Controlling Your Emotions The above summary is simply a guide to help you determine how best to allocate your portfolio. There isn't a really good one-size-fits-all allocation for an investor. Every investor is different—they have different comfort levels, retirement goals, as well as different investments held outside their retirement accounts. Although younger workers should have a lot of stocks in their portfolios, a 90% allocation might feel a little too risky if you are not comfortable stomaching the ups and downs of the stock market or have a lot of stocks held outside your retirement account. But you should never let your emotions drive your allocation strategy. "You need to be careful about letting your emotions take over," Ratner says. "Your main goal should be to set your allocations based on your objectives and time horizon to retirement. Your individual risk tolerance level should only come into play to fine-tune your strategy. Your capacity to assume risk should always trump your tolerance for risk. That's also true for older workers." If you are struggling to determine the most appropriate investment allocations for your retirement account, you may want to consider talking to a financial or investment advisor. You also should revisit Retirement Manager, which is, in part, designed to construct an optimal allocation for you based on many of the factors discussed above.   Morningstar Inc.'s Market Commentary Snapshot At the end of each quarter Morningstar Indexes publishes an assessment of the state of the market and the economy. Here's a snapshot from the 2009 Q3 Morningstar Market Commentary: A year after the collapse of Lehman Brothers sent credit markets into a tailspin, the markets are signaling the economy has finally found its bottom and is now trying to dig itself out of a deep hole. Huge challenges remain with respect to employment, debt levels, and government spending deficits, but the worst appears to be over, and the market largely seems to have shrugged off any concerns. The Morningstar US Market Index posted its biggest quarterly gain in a decade, increasing 16.2% for the quarter, bringing the year-to-date return to 21.2%. Small-cap stocks once again outperformed the broader market, rising 22% in the quarter compared with 21% for mid-caps and 14% for large caps. With 31% returns for the year, small caps and mid caps are outpacing large caps' 18% return by a decent margin. Meanwhile, the Morningstar US Core Bond Index, our broadest measure of the US bond markets, rose 3.3% for the quarter. Finally, the Morningstar Long-Only Index rose 1.3%, and is up 10% for the year.   Q3 Morningstar Indexes   Stocks     US Market Index 16.17   Bonds     Core Bond Index 3.30   Commodities     Long-Only Commodity Index 1.35     Retirement 101: Compound Interest With simple interest you earn interest on your original principal only. With compound interest, you earn interest not only on the principal but also on the accrued interest. Here's how it works—let's say you put $10,000 in your 401(k) and it earned 8% every year. That first year your principal will have grown to $10,800 ($800 earned interest). In the second year that principal would have increased to $11,664 ($1,664 in earned interest—$64 more than year one because of compounding). In 20 years your principal will have grown to $46,609.57—all thanks to the power of compound interest.   Interested in learning more about investing for retirement? Go to Morningstar.com and access the Personal Finance section     Thanks for reading and for remaining a valued Morningstar Online user. Morningstar Associates

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