Anticipate Before You Participate

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 (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.

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

Fund	Weekly	Monthly	Quarterly
Gold Shares Fund	4.46%	10.16%	19.15%
World Precious Minerals Fund	4.19%	10.16%	19.81%
Global Resources Fund	2.80%	6.96%	13.15%
Eastern European Fund	2.75%	6.13%	10.18%
China Region Opportunity Fund	2.35%	5.54%	11.30%
Holmes Growth Fund	2.23%	4.38%	7.60%
All American Equity Fund	2.04%	4.47%	7.30%

HUI	4.77%	9.96%	17.79%
S&P 500	2.05%	4.18%	6.89%

* Sigma is the Greek notation for standard deviation. Normally distributed random data series fall within +1 sigma from the mean around 68% of the time.

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, that 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 average (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.

But because different funds have different sigmas, not all price movements mean the same thing. For instance, looking at the monthly table above for standard deviations, you can see that one sigma for the World Precious Minerals Fund is plus or minus 10.16 percent, while for the Global Resources Fund the sigma is 6.96 percent and the Holmes Growth Fund it is 4.38 percent.

A 4.38 percent movement for the World Precious Minerals Fund or Global Resources Fund in a month is nothing to be surprised about because it would be well within the normal range for these funds. A 10 percent monthly swing in the Global Resources Fund or the Holmes Growth Fund, however, could set off an alert for you because that would be greater than one sigma. In the case of Holmes Growth, in fact, it would be more than two sigma.

When is a fund overbought or oversold?

Quarterly Standard Deviation Movement of the Amex Gold BUGS Index (HUI) 2001-2006 as of 6/14/06

We pay close attention when returns fall outside one sigma during a specific time period, whether that variance is positive or negative. If a stock or fund price rises more than one sigma, it could signal that it is overbought, so we build cash. The mechanics are reversed when a price drops more than one sigma. In that case, it suggests a stock or fund may be oversold, so we consider investing cash to become more fully invested. Investors need to appreciate the volatility of individual stocks, funds, sectors and countries are all different. Volatility is not linear but rather complex. Oscillators are not fool proof but a tool to ask prudent questions about market volatility and managing cash.

Volatility eases over time.

Again, look at the sigma over the weekly, monthly and quarterly time periods for the Eastern European Fund in the previous chart above. You can see that the volatility is not linear. For instance, the Eastern European Fund has a weekly sigma of 2.75 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 6.13 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 for almost all of our funds.

You can also see in the previous chart above that the standard deviations for our gold-oriented funds align closely with the Amex Gold Bugs Index, which tracks the price of gold. And similarly, the sigmas for the All American Equity Fund and the Holmes Growth Fund are comparable with the S&P 500 Index that serves as their benchmark.

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. Investing requires the use of many statistical tools to improve the odds and manage the emotions of fear and greed. Investing is complex and no one system will guarantee success. We use a matrix of models to help guide our decisions. Investing is not linear, and many investors get into trouble following a “guru” or simple system to actively manage their money.

The Four Asset Classes

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.

All opinions expressed and data provided are subject to change without notice. Some of these opinions may not be appropriate to every investor. Diversification does not protect an investor from market risks and does not assure a profit. A program of regular investing doesn't assure a profit or protect against loss in a declining market. You should evaluate your ability to continue in such a program in view of the possibility that you may have to redeem fund shares in periods of declining share prices as well as in periods of rising prices. Foreign and emerging market investing involves special risks such as currency fluctuation and less public disclosure, as well as economic and political risk. 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 5% to 10% of your portfolio in gold or gold stocks. Investing in small- and mid-cap stocks may be more risky and more volatile than investing in large-cap 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.