In 2008 the S&P 500 index declined over 45 percent, and although many pundits had been calling for a market correction, few investors were emotionally and financially prepared for a drop of this magnitude.

Now, as the market continues to languish in 2010, the frustration level has reached a boiling point, with investors fleeing the market like never before, as pointed out in this New York Times article.

The financial industry, always eager to make a buck off of the emotions of investors, are promoting the recent stock market crash as a “black swan” event, and offering up all sorts of newfangled investment products to investors in hopes of protecting them from the next bear market as detailed in Saturday’s Wall Street Journal (subscription required).

Wall Street can offer up non-solutions to investors and charge huge fees on products that won’t get you any closer to your financial goals.  Is it time to turn to them for false problems or turn inward and deal with the reality of our own emotions?

Instead of exacerbating the problem by turning to Wall Street these investors need a dose of “investing” reality with their investment choices.

To put it bluntly, if you are going to invest in the stock market, expect volatility.  Expect long periods of outperformance followed by long periods of underperformance.  Expect years when the stock market goes through the roof (1997-1999) and years of steep declines (2002 & 2008).

When the stock market is hugely overvalued, as it was in 2000, expect periods of low returns.  When the stock market is hugely undervalued, as it was in 1982, expect periods of high returns.  When the stock market is moderately overvalued, as it is today, expect moderately undervalued returns.

But don’t think for a moment that these returns will be generated in a straight line; in fact quite the opposite is going to occur.  You will experience years when the stock market appreciates 30 percent a year, and periods when the stock market declines 30 percent a year.

With this type of volatility, why invest in the stock market at all?  Because over the next 5 to 10 years and beyond, there is a good chance that common stocks will significantly outperform bonds and other fixed income investments, and greatly enhance the returns of portfolios.

What happens if you are retired, and can’t afford to lose money in the stock market?  Don’t invest in the stock market!  This is where an intelligent financial plan enters the picture.  If, after creating your financial plan, you come to the conclusion that a small allocation (maybe 25 – 35 percent) in the stock market is warranted, there is a good chance that even this small allocation will enhance your portfolio returns.  The problem is not the volatile stock market. The problem is the investor – most haven’t created a financial plan to know what an appropriate level of risk and allocation is for thier holdings

I find it interesting that the financial media only talks about “black swan” events on the downside, but never on the upside.  Investors are all too happy to participate in bull markets, but try to run for cover when bear markets come around, instead of accepting bear markets as a normal part of the market cycle.

For the most part, investors across the country “cut their investing teeth” during the markets of 1982-1999, a period that coincided with the introduction of personal retirement accounts, otherwise known as 401k plans.  During this 17 year period, we were treated to a bull market of enormous proportions, and that is what we came to expect.  We never stopped to ponder that if the stock market is going to outperform for a stretch, it will have to underperform for a stretch as well, in the process of reverting to its average annual return of around 10 percent.

How do you handle volatility in the stock market?  Is it something that causes you sleepless nights, or have you created a smart financial plan that recognizes bear markets as a normal part of life, and allocated your assets accordingly?