The conceptual framework of our research is based on the cyclicality of events and asset classes that are related to swings in economic activity. We also believe that dynamic asset allocation and annual rebalancing is the best system to capture swings in asset classes and to manage risk.

To benefit from dynamic asset allocation, managers need to apply the mean-reverting process that strives for stable combinations of growth, inflation and relative risk-adjusted returns between asset classes. Due to swings in different asset classes above or below their long-term mean or average price, advisors should rebalance regularly to better optimize returns and manage risks.

Roger Gibson, author of Asset Allocation: Balancing Financial Risk, believes more can be accomplished with risk management through the breadth of diversification. He believes that the psychological and emotional aspects of investors’ decision-making process create swings in asset classes so higher risk-adjusted returns are achievable through multiple asset class diversification. Further, Roger Gibson believes that investors who embrace broad diversification understand that there will be market environments where certain asset classes will look better than others. For example, toward the end of the roaring bull market in 1997, 1998 and 1999, investors became very anxious about being diversified based on multiple asset classes. However, over the past three years, multiple asset class diversification has paid off significantly.

Roger Gibson believes correlations between asset classes is very important and “in an ideal world, negative correlation is preferred.” Gold and commodities are fairly strongly negatively correlated with the S&P 500 Index. There is a strong countercyclical relationship between commodities and U.S. stocks.

Diversification mitigates risk; it does not completely eliminate it. A multiple asset class strategy, however, held up extraordinarily well over the past three-year bear market. Fixed income, commodities, REITs, gold and gold stocks have been wonderful countercyclical asset classes.

Note the countercyclical nature between these two asset classes or the inverse relationship between the S&P 500 and gold.

For this article, we have gone back in history to show the benefits of gold stocks as a unique and value-added asset class. Our basic assumption is a mean-reverting process that strives to capture price opportunities and better manage risks between the different asset classes.

Since the seminal work of Harry Markowitz in the early 1950s, the practices of investment management have undergone massive change. The interrelationship of individual asset holdings was identified by the noble laureate in the context of the classic investment trade-off between risk and return.

Over the past four decades, investment management attention has been shifting from primary emphasis on asset selection to a more balanced emphasis on diversification and the interrelationship of individual asset classes within the portfolios. Further, modern portfolio theory deals with the rationale for and methods of diversifying and optimizing portfolio returns.

The rationale is simple – to strive to optimize and obtain the best possible expected return, given the level of risk assumed. The method focuses on combining assets whose expected returns are not highly correlated. For this study, we created an efficient frontier, which identifies the optimal percentages of two different, low correlated asset classes over a time period of 30 years. The S&P 500 and TSE Gold and Precious Minerals Index2 are uniquely different asset classes, which have a low correlation to each other.

Portfolio investment decisions are often made with Markowitz’s mean variance (investment model), which focuses on the return-risk relationship of different asset classes and stresses the benefits of diversification in reducing risk.

Behind the mean reversion strategy is the mathematical premise that all prices will eventually move back towards the mean or average price. Further, different asset classes have different cycles, which are measured by the length of time and amplitude (volatility) of their cycle. This rotation above and below the long-term mean price is very clear in the first illustration, which shows gold above its mean price while the S&P 500 is below its mean price.

Financial anomalies suggest that prices may not accurately reflect valuations (Campbell and Shiller, 1988), because people interpret and respond to news differently. Further, empirical studies have documented the benefits of continuous portfolio rebalancing to capture, not guess or chase, under to over valuation cycles and excessive volatility of asset prices.

As mentioned earlier, every asset class has its own elasticity or cyclical pattern whereby it fluctuates from overvalued to undervalued and back again. For the S&P 500, this cycle can be very long. Based on mutual fund money flows, unfortunately, most investors jump from the worst performing asset class to the best performing asset class at the worst possible time. Investors can rebalance their weighting in the different asset classes at least once per year to mitigate the urge to chase performance and concentrate on capturing performance and managing risk in a systematic way.

There is a new interest in gold and gold stocks due to the war with Iraq. We believe this reason for owning gold-related investments is dangerous, because it leads to emotional performance-chasing decisions, which are usually made at the wrong time.

We have done extensive research that demonstrates that gold-related investments behave differently from other asset classes. Also, gold stocks’ low correlation and countercyclical nature to the S&P 500 make it a respectable asset class for diversification. Further, we have illustrated with the efficient frontier diagram that systematic rebalancing of a diversified portfolio is the best method to optimize and capture the significant swings between gold stocks and blue chip stocks.

Although we demonstrate that since 1971 the optimal balance between the S&P 500 Index and TSE Gold and Precious Minerals Index was a 20% gold equity weighting, we have suggested investors allocate a maximum of 5% of their portfolio to our gold funds3. Finally, we suggest that investors rebalance once a year to maintain the 5% weighting.

Frank E. Holmes, Chairman/CEO/CIO of U.S. Global Investors, Inc.

For more complete information about any U.S. Global fund, including charges and expenses, obtain a prospectus by visiting us at www.usfunds.com or call 1-800-US-FUNDS (1-800-873-8637). Read it carefully before you invest or send money. Distributed by U. S. Global Brokerage, Inc.

1- The S&P 500 Stock Index is a widely recognized capitalization-weighted index of 500 common stock prices in U.S. companies.

2- The S&P Toronto Stock Exchange Canadian Gold Capped Sector Index, previously the S&P Toronto Stock Exchange Gold and Precious Minerals Index, is a modified capitalization-weighted index, whose constituents are derived from a subset stock pool of S&P/TSX Composite Index stocks and equity weights are capped 25%.

3- The 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.