Our Wild Market Is Much More Normal Than You Think

Did the stock market seem wilder than usual last year? Well, it was. During a one-week stretch in August, the Dow Jones Industrial Average (INDEX: ^DJI) logged the most volatile string of days since 1932, rising or falling more than 4% in 5 out of 6 trading sessions.

But measured another way, the year may not have been as crazy as you think. Going back to 1928, I looked at how many days the Dow closed either up or down more than 1.5% in each year. It shows that 2011 was indeed a wild one, but hardly unprecedented:

Source: Yahoo! Finance, author's calculations.

In total, there were 51 days in 2011 when the Dow finished up or down more than 1.5%. Since 1928, there are on average 30 days of such high volatility each year. Since 2000, the average has been about 42 wild days per year.

Something else this chart clearly shows: There has been a big jump in market volatility over the last 30 years compared with the 30 before that. The Great Depression in the 1930s saw some of the most volatile years in history. But after that came several decades of calm. From 1947 to 1972, the Dow logged 216 days in total up or down more than 1.5%. Since 2008 -- just four years -- there's already been 242.

The best explanation for the surge in volatility is the increase in high-frequency computer trading. As markets went crazy last summer, Gary Wedbush of Wedbush Securities estimated that as much as 75% of total volume came from high-frequency traders. These traders look to exploit tiny market inefficiencies, not long-term investment opportunities, and can cause wild volatility when they get spooked and exit the market at the same time. That's what happened in May 2010 during the "flash crash," when the Dow fell 1,000 points and recovered a few minutes later.

But rather than gawk or fret over the increased volatility, we should ask: Does it really matter? It's easy to make the case that it doesn't. There have been 15 years since 1928 in which the Dow finished up or down more than 1.5% on more than 50 trading days. After those wild years, the average subsequent five-year market return was about 6% per year -- almost exactly the historic norm. In other words, high volatility in one year doesn't seem to portend poor returns in the following years.

There are actually plenty of years when the opposite is true. The late 1960s saw some of the least volatility in history -- in 1964, there wasn't a single trading day up or down more than 1.5% -- yet in hindsight it was a terrible time to invest, with stocks beginning nearly two decades of flat returns. On the other hand, the most volatile year in history was 1931, which actually ended up being a superb time to buy, with stocks more than doubling within a few years.

Yet most investors, it seems, tend to view volatility the other way. Wild markets spook investors into submission, and calm markets lull them into complacency. This can be incredibly dangerous for those who try to avoid market volatility by cashing out and waiting on the sidelines until things get better. As I've shown before, there have been about 21,000 trading sessions between 1928 and today. During that time, the Dow went from 240 to 12,400, or an average annual growth rate of 5% (this doesn't include dividends). If you missed just 20 of the best days during that period, annual returns fall to 2.6%. In other words, half of the compounded gains took place during 0.09% of days. Most who think they are being smart by trying to avoid volatility end up its biggest victim.

Despite higher volatility, the fundamentals of investing haven't changed. Buying good companies at good prices and holding them for long periods of time still works. Volatility may actually help the process, since it creates more frequent and deeper buying opportunities. As Ben Graham, Warren Buffett's early mentor, used to say, "In the short term, stocks are a voting machine, and in the long term, stocks are a weighing machine." That's as true today as it's ever been.

Check back every Tuesday and Friday for Morgan Housel's columns on finance and economics.

At the time thisarticle was published Fool contributor Morgan Housel doesn't own shares in any of the companies mentioned in this article. Follow him on Twitter @TMFHousel. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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