Anticipate Before You Participate Understanding Market Volatility is Key to Managing Expectations

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 (or one sigma) of their mean 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 (average) 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.

Let's look at the Gold Shares Fund,one of U.S. Global Investors' most volatile funds, as an example of how to use sigma to manage your emotions and volatility.

Over the last five years, the Gold Shares Fund has had a weekly sigma of 4.46 percent. That means if you marked each weekly return for the last five years on a graph, you could expect 68 percent of those marks to be within 4.46 percent above or below the mean return. Ninety-five percent of those marks would predictably fall within 8.92 percent above or below the mean return because that's two sigma.

A gain of 4 percent in a week might sound exceptional for an investment, but for the Gold Shares Fund, that level of return falls within the range of normal over the past five years. Likewise, a weekly drop of 4 percent can sound scary, but if you know the sigma for the Gold Shares Fund, you know that too is within its normal movement.