Who Wants to be Normal?

When you were young, did you dream that one day you would grow up to be fairly normal? Maybe you really set your sights high and hoped to live an amazingly average life? No? We didn't think so. No one dreams of being just "normal." We want to be unique, spectacular, and truly exceptional.

In the world of financial markets though, normal means volatile. Volatility is natural and healthy for markets. Most long-term investors know and believe this in their bones. We accept the fact there will be ups and downs and naturally think that we, being unique and not "normal" investors, will not be spooked by sudden market gyrations. But when periods of "normal" volatility arrive it is scary – downright paralyzing. Headlines like this don't help matters:

Blowing Up the Lab on Wall Street

By Richard Bookstaber, Time

We become overcome with fear. Scared that tomorrow will bring something even worse than today, more bad news, and of course, more losses.

How do we extract ourselves from this current "normality" and take a birds-eye view of the situation? Our short memories don't help. Much of the recent bull market was abnormal. It duped us into believing that the last three years were "normal" when in fact they were anything but.

Volatility can be measured in many different ways but one way to think about it is how big or small daily market moves are. For example, many investors would agree a full day market move over 1%, positive or negative, feels "volatile"—100 basis points is a pretty big move—so let's use that as our measuring stick for this discussion.

The last three years have been very "abnormal" in their lack of volatility using this measurement. From the end of 2002 through the beginning of 2007, daily market returns were above 1% or below -1% just under 13% of the time. That's right, every day when you turned on your computer, TV, or CB radio the S&P 500 had about a 13% chance of being up or down in excess of 1%. That's a breeze – not even once a week! Our readers in Britain had it even better – only experiencing these types of days just over 9% of the time as measured by the FTSE. Talk about smooth sailing!

But is that normal? Far from it. Since 1970, the S&P and FTSE have experienced 1% or greater positive or negative moves from the previous market close over 22% of the time. That's normal volatility.

After enjoying the smooth ride over the past three years, we have come to expect relative tranquility. When anything but "abnormal" returns occur, the media uses words such as "unprecedented" to describe them. Maybe they're "unprecedented" if you're three years old, but anyone who has a spreadsheet and access to some historical data can find out how 2007 stacks up. Daily moves above 1% or below -1% occurred about 20% of the time this year through yesterday – that's neither unprecedented nor even as volatile as the average since 1970.

But don't despair. Even though markets are returning to more normal ranges of volatility, it doesn't mean you need to become a normal investor that focuses on media scare stories. By knowing something others don't, that what we're experiencing is normal and not something to fear, you have the opportunity to move ahead of the investment herd – to be unique, spectacular, or even, as you hoped many years ago, truly sensational.

Source: Thomson Financial Datastream. FTSE All-Share & S&P 500 – Price Returns