The stock market often moves two steps forward, one step back

One of the hardest things to accept about the stock market is its volatility: prices rise and fall day to day, month to month, and year to year. One month an investor’s account has grown to a certain level, and the next month it has fallen back a few percent from that high, making the investor feel like he has “lost” money. Someone who is used to the steady, slow growth of a savings account may find this alarming. They may feel good when their portfolio hits a new high point, only to feel tricked when it inevitably drops back from that peak a few days or weeks later. Investors new to the market since 2003 may have found the big swings of 2007 especially disquieting, given that the three previous years featured remarkably low downward volatility and a fairly steady upward increase.

The truth is that choppy markets are normal: investors who want the potentially higher long-term gains that come with stock investing have to be willing to accept short-term declines. The annualized return on the U.S. stock market—as measured by the Standard & Poor’s 500 Stocks Index—was about 10.4% from Jan. 1926 through Nov. 2007, according to Standard & Poor’s. However, that does not mean stocks went up 10.4% year after year. In 1931, for instance, the market fell by almost 43%. In 1933, it gained 54%. The market fell during 23 calendar years in the period from 1926 through 2006. Despite that, the overall long term gain was over 10% a year.

Investors who get upset when their portfolios fall during a particular month are setting themselves up for disappointment more than a third of the time, on average. From Jan. 1926 through Nov. 2007, the S&P 500 Index fell almost 38% of the time, heading down during 371 of 983 months. Those declines included a 4.2% decline in November 2007. The index fell during four of the first 11 months of 2007, compared to 2006, when it fell during just one calendar month.

How can an investor stay focused while being pummeled by month-to-month declines in his portfolio? Looking back at the recent past may help. For instance, imagine a portfolio that was worth $95,000 at the beginning of the year and had grown to $102,000 in August. The investor would have been pretty happy in August, having enjoyed a return of over 7% in just eight months. Now suppose that the portfolio went up again in September to $105,000, but got knocked back in October to $102,000. Should the investor feel bad because she “lost” $3,000 in October and now has “only” $102,000 in her portfolio? Looking back a few months might make such a feeling appear silly. After all, this investor was quite happy to have $102,000 in August. Why is she upset to have that same amount of money just two months later?

The only investor who should be unhappy is the one who had counted on using $105,000 for a current purchase. In that case, the investor shouldn’t have trusted his money to the market, knowing that short-term volatility can be high. Long-term investors who don’t need to spend all their money today can afford to wait for future highs to boost their portfolios once again.