HardAssetsInvestor

Written by Brad Zigler  |

December 24, 2009

Gold Stock Volatility’s Double Edge

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In a Desktop column earlier this week ("Gold Stocks: Where Are They Now?"), we recapped the recent price performance of the Golden Dozen—12 gold mining issues widely held by HAI readers.

We saw most of these stocks declined as gold tumbled from its early December peak. Most, but not all. For the brief period examined, three issues actually gained ground: Gammon Gold, Inc. (NYSE: GRS), Hecla Mining Corp. (NYSE: HL) and Eldorado Gold Corp. (NYSE: EGO).

Among the losers, there was a wide spread of returns, reflecting the differences in the stocks' inherent volatilities.

That word—volatility—conjures up all sorts of notions in investors' minds. Most of the time, investors are only worried about one type of volatility—the downside kind. Unfortunately, the data supplied to most investors doesn't really help them figure out the level of downside risk they assume.

Volatility is usually expressed as the annualized standard deviation in a stock's return. That translates to the degree of variance—up or down—from a stock's average price over a given period. If all you could know about a stock was this number, you might easily dismiss an investment as too risky.

Take Hecla Mining, for example. Of the dozen stocks examined, Hecla displayed the greatest volatility: Its annualized standard deviation was 65.7 percent. But Hecla also produced the greatest gain, 14.9 percent. In this case, most of Hecla's volatility was the good kind - upside volatility. But you'd have no clue to that looking solely at the standard deviation.

There is a metric that incorporates a stock's return with its volatility to give you a sense of the issue's risk-adjusted return. The Sharpe ratio essentially tells you the reward earned for each unit of risk undertaken.

Because Sharpe ratios employ standard deviations, however, they don't provide much qualitative information about a stock's drawdown risk. Standard deviation assumes risk is equally distributed about the mean, or average, price. In the real world, it usually isn't.

To gauge how much a stock's volatility actually tilts to the downside, you have to rely upon another metric—the Sortino ratio. Put a stock's Sharpe ratio up against its Sortino ratio and you get a clue as to the real risk—the risk of a drawdown— you'd assume with an investment.

Look at the table. See Silver Wheaton Corp.'s (NYSE: SLW) return? Negative. It lost a half-percent between Nov. 10 and Dec. 21. As a result, its Sharpe ratio is negative. But look at the Sortino ratio. It's positive, indicating the negative return's an artifact of current market noise.

The implication? Well, if you screen stocks based upon past performance (and remember, both the Sharpe ratio and the Sortino ratio look back at performance), Silver Wheaton could very well have been filtered out.

Note, too, that you can develop an idea of the quality of a stock's volatility by comparing its Sharpe and Sortino ratios. Newmont Mining Corp. (NYSE: NEM) is a good example. There's wide disparity between its Sharpe ratio (-1.21) and its Sortino (-0.21) counterpart, indicating that drawdowns haven't been particularly protracted or severe.

In a crowded marketplace like gold (now perhaps less crowded than back on Nov. 10), the information provided by metrics like the Sortino ratio gives investors a bit of an edge.

Happy holidays.