What a wild year 2010 was.
It started off with a big rally. Then came the May 6 Flash Crash. Up next was a brutal summer sell-off. Before long, markets went surging into December to the highest level in two years. Up. Down. Sideways. Everything in between.
"2010 could easily be tagged with [the] moniker, 'year of volatility,'" wrote one analyst late last year, with "scores of days with big buying -- and scores of days with big selling." While the Dow returned 9% last year, it fluctuated in a 19.6% range -- from 9,686 to 11,585.
But is that wild? Out of the ordinary? Not particularly. When I went back and crunched the numbers, I discovered that from 1970-2010, the Dow's average annual trough-to-peak range was 27.8% -- during a period in which stocks returned less than 7% per year.
In other words, 2010's volatility was irregularly tame. You think last year was bad? Wait for normalcy to return.
Expect huge volatility this year. And next year. And the year after that. Stocks go up. Stocks go down. It's what they do. These swings, though, don't represent the actual risk you're taking.
My colleague Anand Chokkavelu recently noted that at one point last year, Coca-Cola (NYSE: KO), one of the most stable companies in the world, traded 33% higher than its 2010 low. "The business ain't 33% different," he said.
Same for ExxonMobil (NYSE: XOM). By year's end, Exxon traded 30% higher than its July low. Did the business change 30% between July and December? No. Only the level of opportunity changed.
All this reminded me of great quote I heard last summer from US Global Investors CEO Frank Holmes:
It's a nonevent for stock markets to swing 15% peak-to-trough every year. That's the average. For emerging markets it's 40% per year. Same for gold stocks. That's what you should expect. It's just what markets do: They fluctuate. This scares so many people. But it's important to realize that when they fall, mean reversion becomes a powerful force. The big money to make is when markets are down. Growth is three times greater in emerging-market economics, but there's three times as much volatility. Don't let that scare you. It's normal. Use the volatility to your advantage.
Don't become bitter. Become better.
I love that last line: Don't become bitter. Become better.
This is your brain on stocks
But why do we become so bitter if we know volatility happens every year? A lot of it is human psychology. We have an innate tendency to look for patterns in things, even when we know they're random. Stocks go up, and we think they'll keep going up. They fall, and we think they'll keep falling. Even when we know markets don't operate this way, our brains are set up to assume that they do.
That's where the trouble comes in.
When we anticipate the market's next move based on false patterns, we get a shot of dopamine. When our predictions fail, there's a withdrawal effect. In his excellent book Your Money and Your Brain, Jason Zweig explains how powerful this phenomenon is: "Lay an MRI brain scan of a cocaine addict next to one of somebody who thinks he's about to make money, and the pattern of neurons firing in the two images are 'virtually right on top of each other.'"
Once we think we've found a pattern -- markets going up, or headed down -- we literally become addicted to it, unable to accept that volatility invariably shakes things up. "Except the substance you're hooked on," Zweig explains, "isn't alcohol or cocaine. It's money." This is why so many investors, novice or otherwise, fail miserably. They're physically allergic to volatility.
The single most challenging, and most important, aspect of investing is recognizing that the rollercoaster markets that hurt the most can also lead to long-term opportunity. Come to accept volatility as your friend. Its alarming facade conceals real opportunity.
Fool contributor Morgan Housel owns shares of Exxon. Coca-Cola is a Motley Fool Inside Value recommendation. Coca-Cola is a Motley Fool Income Investor recommendation. The Fool owns shares of Coca-Cola, and ExxonMobil. 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.
