Anticipate Before You Participate

By Frank E. Holmes         June 21, 2006 www.usfunds.com

Understanding Market Volatility of the HUI is Key to Managing Expectations for Gold Stocks and Mutual Funds.

A fundamental aspect of investing is deciding how much risk and volatility you’re comfortable with, and then choosing investments that fit into that comfort zone.

Generally speaking, the greater the volatility of a given security, the higher its risk for the investor. And the greater the risk you’re willing to take, the greater the potential profits you could reap. So taking the comparison to its logical conclusion, the greater the volatility, the greater the potential profits and, of course, the greater the potential losses.

Investors may find it difficult and time-consuming to figure out which funds provide the optimal balance of risk, volatility and reward, but it’s worth the effort. Understanding the volatility and risks involved with the markets is vitally important to maintain both your investments and your emotional health. Chasing performance or trying to guess tops and bottoms in share prices can be both emotionally and financially draining.

Standard deviation, also known as “sigma,” is a valuable statistical tool for gauging a fund’s volatility, as it measures how much the fund’s returns vary from their mean, or average, over a given period of time.

For most funds, returns will be within one standard deviation (one sigma) of their mean (average) 68 percent of the time and within two standard deviations (two sigma) of the mean 95 percent of the time. Returns fall within three sigma 99 percent of the time.

You can see this basic concept in the bell-shaped curve to the right. The straight line down from the highest point on the curve is the mean return over the specified time period. The area in blue is one sigma above and below the mean. By adding the area in green, you have gone out two sigma on either side of the mean. The yellow segments expand the white area to three sigma.

As an investor, sigma can help you understand the level of volatility to expect from a particular investment. That knowledge allows you to manage your risk and it keeps you from getting overly excited when your investment’s ups and downs fall within its normal range. It can also help you identify when to buy or sell a stock or a fund.

Let’s look at the Amex Gold BUGS Index (HUI) as an example of how to use sigma.

Magnitude for 1 standard deviation (1 sigma*) as of 6/14/06

Over the last five years as of 6/14/06, the HUI has had a quarterly sigma of 17.79 percent. That means if you marked each quarterly return for the last five years on a graph, you could expect 68 percent of those marks to be within 17.79 percent above or below the average (mean) return. Ninety-five percent of those marks would predictably fall within 35.58 percent above or below the mean return because that’s two sigma.

A gain of 10 percent in a quarter might sound exceptional for an investment, but for the HUI, that level of return falls within the range of normal over the past five years. Likewise, a quarterly drop of 10 percent can sound scary, but if you know the sigma for the HUI, you know that too is within its normal movement.

When is an index overbought or oversold?

Quarterly Standard Deviation Movement of the HUI – 2001-2006 as of 6/14/06

You should pay closer attention when returns fall outside one sigma during a specific time period, whether that variance is positive or negative. If an index’s performance rises more than one sigma, it could signal that it is overbought, so you might consider selling or holding off on buying. That’s because, statistically, there is only a 16 percent chance that it will go higher. The mechanics are reversed when a performance drops more than one sigma. In that case, it suggests the index’s stocks may be oversold, so you might consider buying or not selling because the chance of further loss is only 16 percent.

Volatility eases over time.

Again, look at the sigma over the weekly, monthly and quarterly time periods for the HUI. You can see that the volatility is not linear. For instance, the HUI has a weekly sigma of 4.77 percent, so one might think that the monthly sigma should be four times higher because there are four weeks in a month. But in reality, the monthly sigma of 9.96 percent is a little more than double the weekly figure. Likewise there are three months in a quarter, but the quarterly sigma was less than double the monthly number.

Investor psychology suggests that investors are more comfortable buying a stock after it has moved up and are more willing to sell when it declines sharply. Many investors use the 200 day and the 50 day moving average to make their decisions, however, this simple process can be problematic when the sectors are more volatile. We believe it is wiser to use dollar-cost averaging and set limits on exposure to any asset class and rebalance annually to catch, not chase volatility.

Please consider carefully the fund’s investment objectives, risks, charges and expenses. For this and other important information, obtain a fund prospectus by visiting www.usfunds.com or by calling 1-800-US-FUNDS (1-800-873-8637). Read it carefully before investing. Distributed by U.S. Global Brokerage, Inc.

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All opinions expressed and data provided are subject to change without notice. Some of these opinions may not be appropriate to every investor. Gold funds may be susceptible to adverse economic, political or regulatory developments due to concentrating in a single theme. The price of gold is subject to substantial price fluctuations over short periods of time and may be affected by unpredicted international monetary and political policies. We suggest investing no more than 3% to 5% of your portfolio in gold or gold stocks. The AMEX Gold Bugs Index (HUI) is a modified equal-dollar weighted index of companies involved in major gold mining. The S&P 500 Stock Index is a widely recognized capitalization-weighted index of 500 common stock prices in U.S. companies.