Volatility refers to the daily ups and downs of investment values. Much maligned by investors and the media when prices plummet, volatility is welcomed when investment values head upward. Yet, when was the last time you heard anyone use the word “volatile” to describe prices going up?

How volatility differs from a roller coaster

Volatility is often equated with riding a roller coaster, but there's one key difference: When a roller coaster ride ends, you're exactly where you started.

That's not necessarily the case with volatility. Thanks to its upside, U.S. stock values have trended upward over the long term despite steep periodic declines, such as the one that occurred in late February and early March of 2007. From a long-term perspective, the declines don't look nearly as steep as they probably felt at the time.

Two perspectives on volatility

The first chart below illustrates that roller coaster feeling. It shows returns over 25 years, but from the perspective of year-to-year volatility.

Year-Over-Year Returns Can Swing Dramatically 

Annual Returns of S&P 500 Index 1982 – 2006

The second chart uses the same data—returns of the S&P 500 Index over 25 years—but instead of displaying individual years, it shows the cumulative return over the long term.

If you develop the ability to keep your focus on the long term, you'll have mastered the primary approach to living with volatility's downside.

Living with volatility's downside

Most folks can get reasonably comfortable with volatility by using 4 basic investment strategies:

• Focus on the long term
• Invest regularly
• Diversify your investments
• Keep in touch with your financial advisor

Focus on the long term. One key to living with volatility is focusing on long-term results rather than the daily bumps along the way.

That can be especially difficult during prolonged market declines fed by daily injections of bad news. Investors living through the aftermath of the stock bubble that burst in March 2000 were acutely aware of how challenging it can be to stay focused on the long term.

Invest regularly. Also called dollar-cost averaging, an automatic investment program is another strategy for living with volatility's downside and taking advantage of its upside.

You don't need to worry about the best time to invest when you put away the same amount every month, but like most investing strategies, it doesn't guarantee a profit or prevent losses.

This strategy can help reduce anxiety about portfolio declines. However, by focusing attention on the bright side—when the market is down, you're buying shares at bargain prices—but it also requires you to continue investing despite fluctuating prices. Before starting a dollar-cost averaging plan, consider your ability to continuing buying shares through prolonged market and economic slumps.

Diversify your investments. No one asset category does well all the time, so it can be a good idea to put your eggs in a variety of baskets. If some of your investments are down, others may be up.

One area of the market can be hot for several years, like large U.S. growth stocks in the second half of the 1990s. During those years, owners of diversified portfolios may not have had much to say when friends bragged about outsized returns in their 100% growth stock portfolios. But the growth stock free fall that started in March 2000 underscored the value of diversification as a strategy for living with volatility's downs.