Get Used to Market Volatility

We’d all be a lot happier if the stock market always behaved much like it did in the first quarter of 2012. Standard & Poor’s 500-stock index returned 12.6%, and the market suffered few sharp drops or rises. It was smooth sailing.

SEE ALSO: Our Special Report on Investing in Volatile Markets

Unfortunately, the market’s path to profits is almost never so placid. Such times, alas, occur only rarely.

In an average calendar year, you can expect stocks to tumble 13.5%! That’s how much the S&P 500 has fallen in price intra-year, on average, since 1928, according to the Leuthold Group, a Minneapolis-based investment research firm.

Let me elaborate. I’m not saying the stock market suffers a net loss of 13.5% in an average year. The S&P 500 has returned an annualized 9.8% (including dividends) since 1926. But during the average calendar year, the index experiences a 13.5% decline from peak to trough before (usually) rebounding. Looking at it another way, to reap the long-term profits that the stock market has historically produced, investors must be able to tolerate the volatility that comes with those gains.

The market has been especially volatile of late, with investors reacting to developments in the festering crisis in Europe. But from the market’s peak this year on April 2 through June 25, the S&P index has fallen only 7.0%.

Take a look at some other past intra-year losses. In 2011, the market plummeted 19.4% after Congress and the White House dithered endlessly over raising the debt ceiling, and Standard & Poor’s downgraded the nation’s credit rating. We subsequently made up for those losses and moved higher -- but it was a gut-wrenching ride.

Last year was hardly unique. The S&P tumbled 16.0% intra year in 2010, 27.6% in 2009 and 47.3% in 2008. In 2007, as the 2007-2009 bear market was getting under way, stocks lost only 10.1% at their worst.

In spite of those vicious selloffs, the S&P has nearly doubled in price since the market hit bottom on March 9, 2009. As hard as it may have been to do, you were well rewarded for staying put with your seat belt fastened.

High volatility doesn’t necessarily predict lousy stock returns, nor do tranquil markets presage big gains. Consider the 2003-2006 period, during which the market advanced relatively calmly. The biggest intra-year loss over that span was 14.1%, in 2003. The other three years each saw maximum losses of 8.2% or less.

But even as the market was behaving so politely, it was getting ready to rob us of serious money. The S&P lost 55.3% in the bear market that started in October 2007 -- its biggest decline since the Great Depression.

The 1990s were likewise placid. In 1990, stocks fell 19.9% intra year, and in 1998, they dropped 19.3%. Other than that, the biggest intra-year loss was 12.1%, in 1999.

Yup, those were the good old days. But, of course, they were followed by the popping of the tech bubble, in 2000, kicking off one of the most dismal long-term periods in market history -- the one we’re still experiencing.

Investors are plainly agitated by the stock market’s wild swings. You can see it in their relentless withdrawals from stock funds and their equally relentless purchases of bond funds.

Leuthold’s Douglas Ramsey calls the longing for low volatility nothing short of an “investment mania. Today’s investment mania is volatility minimization.” Witness Treasury bills, which yield practically nothing, and Treasury bonds, which yield only a little more. Yet investors large and small continue to flee into these “safe” assets. When interest rates rise, as they inevitably will, Treasury bonds will plunge in value.

Ramsey adds: “Volatility is endemic to the game, and we find today’s cost of avoiding it to be exceptionally (and in most cases, unacceptably) high.”

Steven T. Goldberg is an investment adviser in the Washington, D.C. area.

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