You may reward students for outstanding work with five gold stars. And five-star ratings drive many of our decisions, from booking quality hotels and air travel to dining in style. Star ratings also provide peace of mind – ask anyone who drives a car with a five-star crash test rating. Five stars can help you make an educated purchase, but won’t prevent accidents or guarantee a flawless experience.
The same is true in the stock market. A highly rated stock can crash and burn just like a low-rated stock, no apologies. So why do investment ratings matter at all? When used as one factor – not the only factor – in making investment decisions, they can provide valuable insight.
What's Behind the Stars?
Stocks, funds and annuities are rated by investment research firms, and no two ratings systems are exactly the same. They generally fall into categories: quantitative (measuring past performance, benchmarks, etc.); qualitative (looking at management, risk/return objectives, consistency, etc.); or a combination of both. While stars are the most widely recognized rating, some firms use a system of letters or numbers to rate companies and funds.
It’s important to note there are rating companies – such as Morningstar – that strive to be as objective as possible when rating an investment. Be sure that the rating you are reviewing is not simply part of a marketing campaign to push a specific investment. In addition, ratings such as Morningstar's are backward-looking. That is, they compare past performance – the stock's risk and reward – to come up with a rating. As you well know, past performance is not an indication of future results.
In a typical five-star stock rating system, analysts assess the fair value of a company, considering income statements, cash flow, projections and other financial data. They compare fair value with the current price (or market value) of the stock. Stocks trading at a discount to fair value get more stars, while stocks trading above fair value get fewer stars. Again, you need to make sure this that analysis is objective. Many broker/dealers use such ratings to push stocks, but keep in mind that they typically get a commission on stock sales and that can affect their recommendations.
A mutual fund star rating also considers how fees affect overall performance, as well as the fund manager’s track record, ability and style. Ratings of annuities – similar to mutual fund ratings – are sometimes available, but ratings of the issuing companies are more common. Insurance companies that issue annuities are often rated by AM Best, Moody's, Standard & Poor's and Fitch. The ratings reflect the raters’ assessment of the insurance companies’ ability to meet their obligations over the long term and under distressing market conditions.
A simple star rating can help you select stocks, funds or annuities that appear to be fairly priced, well-run and cost-efficient – if the ratings are issued by a reputable research firm. But it’s important to remember that ratings are not perfect. Sometimes they are wrong, and they cannot predict future results.
Don’t Get Star-Struck
Star ratings can provide helpful information for comparing investments, but five stars are meaningless if they don’t match your unique goals, timeline and risk tolerance. If you use star ratings, make sure they are only one component of your investment decision. Compare levels of risk, peer performance, fees and expenses. To learn more about mutual funds, read "Understanding Mutual Funds."