Volatility Will Make You Rich

Just when you think the worst is over, the market throws you for another loop.

Consider last Tuesday. Everything seemed great for stock investors. The Dow was above 13,000, and the S&P 500 was at its highest levels since January. Technical analysts were expounding on how significant the breakout was, and some even proclaimed that the downtrend was over.

But somebody forgot to tell the market. Breaching all of those "important" technical levels and sending investor sentiment back into the cellar, the Dow dropped 200 points the next day and ended down 300 points for the week.

Bumpy days are here again
If you're a relatively new investor, the dramatic ups and downs you've been seeing from the markets lately may come as a shock. But what's unusual is how calmly the markets acted in the years before the recent downturn.

One way to look at historical volatility is through the CBOE Volatility Index, or VIX. Created in 1990 and based on prices of stock index options, the VIX measures the extent to which options traders believe stock prices will move in the near future.

The VIX has risen sharply over the past year and a half. But that rise came up from extremely low levels -- the lowest since 1993-94. Looking at the readings from 1997 to 2003, we'd have to say that today's VIX looks downright sanguine.

Capitalize on fear
Many see volatility as a necessary evil in investing. In a perfect world, these folks would prefer slow, steady gains of 8%-10% annually without any big bumps along the way.

Yet volatility isn't always an enemy. By pushing stock prices up and down, volatility gives disciplined investors opportunities to buy shares of their favorite stocks cheaply. If you take advantage of those chances to pick up bargains, you can greatly enhance your returns.

For example, look at what happened last summer. In mid-July, the S&P 500 hit what was then a new record high. Then the bottom fell out of the markets, as battered homebuilders such as Beazer Homes (NYSE: BZH) reported bad earnings and offered dismal forecasts. Just four weeks later, the S&P had fallen by more than 9%.

If you panicked and sold at the lows, you made two mistakes. First, you locked in big losses compared with what you could have gotten by selling just weeks before. But more importantly, when the S&P recovered to hit new record highs just two months later, you missed out on big gains.

Many individual stocks suffered double-digit drops in July and August, as this table shows. But if you held on through the volatility, you made back much or all of your losses.

Moreover, if you had the guts to buy at those lows, you did even better than long-term buy-and-hold investors who had the discipline to hang on to their shares.

Don't think of volatility as your enemy. Although big price drops can bring temporary pain to your portfolio, they also give you a shot to pick up stock market bargains and multiply your returns.

For more on taking advantage of market volatility, read about:

• How you can profit from bad news.
• What you need to do to make this your best investing year yet.
• What stock is outrageously cheap.