What investors should learn from last year

With a 2.1 percent total return on the S&P 500 for the year, 2011 might not seem to have offered much for investors. But what it lacked in performance, it made up for in lessons provided.

The first half of the year was noteworthy for the resilience the stock market displayed. Despite sluggish economic growth, the Japanese earthquake and tsunami, and the stirrings of trouble in the eurozone, the S&P 500 notched a 6.1 percent return in the first six months of the year.

But then things began to get ugly. Beginning in late July, investors began to eye Europe with increasing anxiety, fearful of how the deepening crisis might impact the global economy. Those fears manifested themselves in some of the most stomach-churning markets we've seen in years. One two-week span in August saw six days in which the S&P 500 gained or lost at least 4 percent. The year's gains quickly evaporated, and the index posted a loss of 14 percent in the third quarter.

Unsurprisingly, investors responded the way most investors tend to respond to such volatility -- they bailed. Investors pulled an amazing $70 billion out of domestic stock funds in the third quarter of the year.

And who could blame them? Everywhere you turned, you found not just another threat to the global economy's parlous state, but depressing evidence that the world was sorely lacking in the political leadership necessary to navigate these unprecedented circumstances. Seeking the safety of the sidelines surely seemed a rational choice.

But, as often happens, the choice that seems blindingly obvious was in fact the wrong one. After losing 14 percent in the third quarter, the S&P 500 bounced back in the fourth quarter, notching a 12 percent return. Without accounting for dividends, the index ended the year nearly exactly where it had started, at 1,257.60.

In other words, the stock market in 2011 was a roller coaster ride in all but the literal sense, providing a white-knuckled experience that left participants questioning their judgement before dumping them right back where they started.

Well, almost where they started.

The problem is that millions of investors fled along the way, pulling their money out of stocks when all seemed hopeless. Many -- probably most -- will be back, once they feel that the volatility has subsided. The problem is that investors' impulses compel them to sell when prices are at their lowest, and buy back in only when stocks seem "safer" (that is, when they've recouped their losses).

Obviously, it would be hard to come up with a dumber way to try to build wealth than selling low and buying high. But the nearly flat markets of 2011 provide a wonderful illustration of just how dumb it is to act upon the market's day-to-day changes. Yes, in the midst of a crisis every impulse in your body is telling you to act upon what's happening right in front of you -- to duck the punch that's obviously coming. But the passage of time shows us that what's happening right in front of you on any given day in the market is something that's truly full of sound and fury, signifying nothing. It's something that is prudently and profitably ignored.

Several centuries ago the mathematician Blaise Pascal wrote that most of the harm in the world comes from man's inability to sit quietly in a room. The year 2011 showed that most of the harm inflicted on investors' portfolios comes from their inability to sit placidly in front of a computer when all hell is breaking loose around them.