Over the last few years, the wild gyrations of the stock market have convinced some investors to stay on the sidelines. And that’s too bad, because they’ve missed out on a valuable opportunity to grow their nest egg.
Are our fears getting the better of us, or is the stock market truly becoming more volatile?
Volatility has always been part and parcel of the stock market. Since 1928, the S&P 500 has averaged a 13.5% drop at some point during the calendar year (before recovering), according to research by the Leuthold Group in Minneapolis.
However, it does appear that volatility is increasing in recent years. “The market is more volatile today than it has been at any time over the last five decades,” says a recent article directed at investment advisers.
One way to measure volatility is by looking at how many days per year the S&P 500 stock index fluctuated in price by more than 1%.
- From 1928 to 2011, the S&P fluctuated by over 1% on about 20% of all trading days.
- In 2011, it moved over 1% on almost 40% of all trading days.
- In 2008, at the crisis’ peak, the S&P rose or fell more than 1% on over 50% of all trading days.
- And let’s not forget the famous May 6, 2010 Flash Crash when the Dow Jones Industrial Average plunged 1000 points (about 9%) before recovering just minutes later.
What’s the explanation for the increase in volatility?
Most market analysts agree that short-term trading is on the increase, and may be one of the culprits. Hedge fund managers and other high-frequency traders use ETFs (exchange traded funds) to trade enormous volumes of stocks and bonds throughout the day.
“Nadia Papagiannis, director of alternative fund research at Morningstar in Chicago, points to high-volume traders as the source of much of today’s stock market volatility.” She says that “high-frequency traders, who use automated trading programs to trade in and out of securities in a nanosecond, now represent 60 percent of total U.S. stock-trading volume.”
And of course, the overall global crisis and high level of uncertainty also contribute to market anxiety and volatility.
What’s the best way to deal with volatility?
Accept it as a fact of life. Markets go up, and markets go down. To be a successful investor, you need to be able to hang on through some rough-and-tumble days. The reward is a chance at obtaining the stock market’s average 9.8% annual return, better than other investments are likely to achieve.
Trying to avoid volatility can actually hurt you. Lately, investors have rushed toward low risk investments like CDs, Treasury bonds and other fixed income investments. Ironically, that kind of extreme risk avoidance can almost guarantee that those investors will fail to meet their financial goals.
Volatility doesn’t always mean bad things are ahead. Rough markets can result in good returns; calm markets may precede dangerous drops. Volatility reflects anxiety and uncertainty as emotions dominate investment decision-making. But don’t forget that uncertainty creates opportunity for those who can master their emotions and think rationally in times of crisis.
When the market gets crazy, resist the urge to trade impulsively or in a panic, and stay focused on long-term goals. Have the discipline to stick to your strategy. If you can’t stay disciplined, hire an investment adviser who can do it for you.