Investors this summer got a rude taste of something many of them had forgotten: volatility. Knowing what a stock (or any other investment) returns over time is not enough. You need to know how consistent those returns will be. Think of a baseball player who hits .198 one year, .376 the next and .280 the next. Computing his three-year batting average of .285 tells you little about the volatile, inconsistent nature of his hitting.

Measuring the jolts. A common measure of stock volatility -- that is, the extremes of the market's ups and downs -- is standard deviation, an expression of how much prices vary from their own average movement. History shows that the standard deviation of the U.S. market as a whole has been about 20 percentage points. Because stocks (using Standard & Poor's 500-stock index as a benchmark) have returned an annualized average of about 10%, two-thirds of the time we can expect S&P returns to range between -10% and +30%. Lately, however, returns have fallen into a much narrower range. For the four years starting in 2003, the S&P returned 29%, 11%, 5% and 16%. For the three years that ended last June 30, the standard deviation of the S&P was a mere 7. No wonder investors had gotten used to smooth sailing.

Why have returns been so steady? One factor is the U.S. economy's recent consistency, with low inflation, steady interest rates and a gross domestic product that has risen within a narrow band since 2003 at annual rates of 2.5%, 3.6%, 3.1%, 2.9% and (for the first half of 2007) 2.3%. But in midsummer, problems showed up in the mortgage market that raised serious uncertainties.

As measured by the Chicago Board Options Exchange's Volatility Index, or VIX, the volatility of the stock market suddenly became more violent in July. The VIX, which uses a complex algorithm to measure investors' expectations of near-term volatility, declined for four straight years starting in 2003 and finished 2006 at a record low. By early September, however, the index had nearly doubled, which means that investors were riding a roller coaster and expecting more stomach-churning adventures to come.

A stock's price reflects the present value of its future earnings. Those earnings depend on the course of the economy, and investors became unsure of what to make of that course. It looked bright one day and dim the next, so prices bounced wildly. In addition, market psychology, which in the short term can have little to do with facts or calm analysis, exacerbates volatility. Yale economist Robert Shiller began his 1992 book, Market Volatility, with a quotation from the 18th-century novelist Henry Fielding: "Fashion is the great governor of the world; it presides not only in matters of dress and amusement, but in law, physics, politics, religion, and all other things of the gravest kind." For stocks, fear became fashion.

In part, the new volatility was a numerical illusion. On August 9, for example, the Dow Jones industrial average dropped 387 points. That sounds like a lot until you realize the loss was 2.8% -- or equal to just a 70-point decline in 1990. But mostly, the renewed volatility is normal. It's the way the stock market works. And, believe it or not, it's a good thing.

Reward for risk. Imagine a world in which stock investments performed the same year after year. A stock would be like a certificate of deposit. It would have no volatility -- except for the effects of inflation -- but it wouldn't put much money in your pocket, either. Stocks have returned an annual average of more than 10% over the past 80 years because they are volatile. To put it another way: A higher return is your reward for investing in a riskier asset.

You have to work to make money in the stock market. To a small degree, the work entails picking good companies or good mutual funds. But most of the work is enduring the anxiety and fear of owning something that could be worth a good deal less tomorrow than it is today. The challenge is to hang on to good firms through thick and thin.

MORE: Kiplinger.com | Investing | Markets | Magazine

TOOLS:   E-Mail Article  |  Print Article  |  Reprint Article  |  Content Licensing & Partnerships

E-MAIL ALERTS: Keep up-to-date with the latest Kiplinger has to offer

SAVE, SHARE & DISCUSS:    |   |   |   |   |    

ADD HEADLINES: