# What to make of historical stock market volatility?

I looked on Google Finance today at the DJIA, and kept backing up the time window until I saw the whole display they had, from 1971 until today (Oct 2011).

It seemed to me that the volatility--the ups and downs--has increased a great deal since the 70s. In fact, it seemed rather steady (climbing smoothly) until about 1997 or so, when it began getting a "jaggier" look to it:

What should the average person make of this, in terms of personal finance decisions? For example, naively, it seems to me that I would rather have been a buy-and-hold investor in the 1971--1997 era, since for the most part I would see modest but steady returns, and I would not have as many "scares" with sharp market drops. Then again, there is an argument that I should prefer volatility, to take advantage of these swings, and buy on the sharp drops.

I am not an investor (yet), but find the volatility kind of off-putting. The ups ad downs get reported each day in the financial news, but the overall take-home is the market is the same place it was in Apr 2010, a year and a half ago.

So, what should the small investor-wannabe make of the era of increased volatility? Why does it occur, and how should it inform our financial decisions?

The first thing to realize is that the type of chart you saw is not appropriate for long-term comparisons. The vertical axis uses a linear scale, where each unit occupies the same amount of space. This is visually misleading because the relevant information at any point in the chart is "how much is the value going up or down?" and "how much" change depends on how much the value of the investment is at that moment. For example, if you buy something at $10 and the price changes$1, that is significant, 10%. If you buy something at $1000 and the price changes$1, that is not so significant, only 0.1%. The problem in that chart is that 100 Dow points occupy the same space whether the Dow is at 870 or 10800.

To get a better feel for the volatility, you should use a log (logarithmic) scale. Google has an option for this. Using it shows:

In this chart you can see that the volatility appears much less extreme in recent years. True, the 2006-2009 change is the largest drop, and there might be slightly higher volatility generally, but it is not nearly as extreme-looking. The drops in 1974 and 1987 can be seen to be significant.

• +1, you put it better than I could. Excellent explanation. – JoeTaxpayer Oct 21 '11 at 22:57
• I wonder if anyone's constructed a back dated VIX time series... – jldugger Oct 22 '11 at 2:41