Understanding The ‘Santa Claus Rally’ On Wall Street

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This much we know: More often than not, stocks rise during the week between Christmas and New Year’s Day.

Not 100% of the time, but enough to lead people to expect the rally and to invest ahead of it, creating conditions for — a Santa Claus rally! Since 1969, the stock market has gained 1.4% during that week. Another study dating back to 1896 showed a 1.7% gain and rising stock values 77% of the time

So should you get in now? Here’s the problem with any kind of market-timing bet such as buying ahead of a Santa Claus Rally. Sometimes it fails. That can lead you to sell just as quickly as you bought, locking in a loss.

There are lot of competing ideas about why the Santa Claus rally seems to be persistent.

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One is that many of the market’s large institutional participants are out of town. What’s left are strivers hoping to make a buck, leading to more big-bet trades and a general push higher.

Another likely culprit might be fund managers. Their year is ending and whatever chance they have to improve performance is at hand. Cash sitting in a fund looks bad, so it may be that cash-heavy managers are rushing to take positions.

Another is taxes. Investors can be in a hurry to make trades ahead of the year-end to manage their tax strategy, selling in order to record losses they can write off against gains.

The result of that selling activity is energized buying after the New Year, a bump in the markets known as “the January effect.”

That makes intuitive sense. Certainly there are plenty of investors looking to game the tax system. The end of the year is their last chance to get it done.

If those investors bailed out in December, the thinking goes, it might lead other investors to snap up dumped shares as prices fall, resulting in more activity and overall higher prices at the end of the year.

The problem with all of these programmatic trading concepts is that that everyone else knows about them, too. In time, people anticipate the slumps and bumps and begin to trade ahead of them, just in case.

In turn, that preemptive trading smooths out any potential for gain while increasing the risk of taking losses.

Emotion-free

It’s one thing if you can be emotionless about the numbers in front of you. But that’s not how human beings are wired. If you buy expecting prices to rise, it feels that much worse when things don’t go the way you expect.

Meanwhile, if you choose to ignore the supposed surefire trends and just contribute steadily to your investments, a funny thing happens — you get the bumps upward anyway.

Investing on autopilot means you are pay little or no attention to the day-to-day prices of your investments. If they happen to fall as you contribute and rebalance, that’s a win. You are buying more cheaply.

By failing to pay attention to the current price, you also reduce the risk of overreacting and selling out at a lower price. That protects you from losses you do not need to take.

As with all supposed market trends, the Santa Claus rally is one to ignore roundly. Better to review your periodic, automated investment levels and proceed into the New Year blissfully invested and unaware, but winning Christmas just the same.

Investor Facts: What Is Volatility?

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Volatility is the relative movement of the price of an investment higher or lower compared to other investments or to an investment index.

Investments such as stocks and bonds are priced daily, even minute to minute, by the markets. Investors and short-term traders bid the price higher or lower based on their collective expectation of future growth and, by extension, future demand for shares in those investments.

Volatility is a way of describing how much that price can vary in a period of time. Some investments are extremely volatile, rising and falling by significant percentage values during a single trading day. Others are not volatile at all, maintaining nearly the same price for days or weeks.

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Generally speaking, the less volatile investments make up for that slow change in price by paying interest or dividend income to the investment’s owner. The more volatile investments often do not pay an income but usually hit a higher average price as the weeks and months pass.

Some of them do not. Volatility can signify instability, too, resulting in bankruptcy and an investment value that declines permanently.

When people consider which investments to own, often they say they like the idea of buying something deemed “low risk.” Nevertheless, they want their investments to appreciate in price in a reasonable period of time so that they can sell the investment for a profit.

Investors thus confuse volatility and risk. They believe that an investment that changes in price dramatically is risky while one that steadily rises, albeit slowly, is not risky.

The opposite can be true. For instance, a typical U.S. stock might be quite volatile day-to-day but represent a significant opportunity to profit if one is willing to ignore the trading action and steadily reinvest.

Meanwhile, the U.S. government bond market has been a reliable long-term investment for many years and very much not volatile — if you discount the occasional hair-raising crash.

Volatility for long-term investors

These two investment types are by far the most common, and they are geared to different factors in the economy. The stock holding is based on the idea of a growing economy, while the bond investment is tied to the interest rate.

The economy is tough to figure out. The fortunes of any one company can be affected by myriad factors, for instance the cost of credit, labor supply, raw materials expenses, competition and consumer demand.

The interest rate, meanwhile, is managed by the U.S. Federal Reserve. It can be baffling to guess what the Fed might do next and why, but it definitely moves more slowly and methodically than the inner workings of a for-profit corporation.

If the economy slows, stocks will react quickly and perhaps strongly to the change. The bond market might react later on, in response to a Fed policy decision taken only after a long deliberation and usually in small, incremental steps.

The result is that stocks are, broadly speaking, more likely to change price and by wider margins than bonds. They are more volatile.

Over a period of decades, however, you are likely to find that the stock investment has grown more than the bond investment, despite the volatility.

So which is the bigger risk? If your goal is to grow your savings faster than inflation, the bond market is a greater risk to your plan than the stock market.

Likewise, if your goal is to protect your savings from loss and to generate a reliable income, the stock market is the greater risk.

A portfolio of stocks and bonds offers a chance to generate growth while riding the brake on risk as you get nearer to that second goal of creating income in retirement.

Dollar Cost Averaging Means Black Friday For Investors Is Every Day

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If you’re reading this column you were probably not in the scrum of shoppers out trying to score a cheap flat-screen TV. And thank goodness for that!

Of course, we all like a deal, but consider what Black Friday means to retailers. It’s the day, according to the lore, that big stores hope to break even for the year.

It’s the day their company goes from red (losing money) to black (profitable).

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As a retailer, you have to spend an excruciatingly long time knowing that the year is a loss. All of the spring and summer and a good bit of the fall, too.

Only on the day after Thanksgiving do you expect to turn a profit. Then you hope to pile on the profits through Christmas, when people do the most shopping.

For an investor, the idea that you lose money for months and then become profitable later is hard to imagine. We would vastly prefer, naturally, to buy a stock that never goes into the red, right?

If only it were that simple! Yet it is easy to get the best prices on stocks over and over, and that’s rebalancing and dollar cost averaging.

Over the long run, that data shows us that stocks generally rise in value. Which stocks is impossible to say, but the entire stock market tends to rise at about twice the rate of the whole economy.

Why that is has to do with dividends. Reinvested dividends add to the return from rising stock prices. Rebalancing means you buy stock using that dividend cash, your contributions and gains from other parts of your portfolio, say, from bonds or real estate.

Over time, it’s likely that you will buy stocks when they are relatively expensive. In those times, you will end up buying fewer shares, of course. Your dollars won’t go as far.

Other times, you will buy at lower prices. That means you will get more shares for each dollar.

This happens over and over, a series of mini Black Fridays, resulting in the long-term effect of capturing more stock at favorable pricing even as the market average continues to climb with the economy.

Lowering cost

Financial advisors refer to this as dollar cost averaging, and it works. Over years of investing, the more dollars you put in regularly and without concern over the current share price, the more it works.

Diversification through index investing, meanwhile, lowers your overall cost of investing by lowering your risk of picking the wrong stocks at the wrong time or selling the wrong stocks at the wrong time.

Because such investing is low cost by design, you end up owning not an investment but the asset class, a proven means of capturing a higher total return. Reinvesting using dollar cost averaging reinforces that effect over and over.

You don’t even have to really think about it, plus you don’t have to remember to get out of bed the day after Thanksgiving, drive to some store and fight for a bargain. It’s already right there in your hands.

Investor Facts: What Is Short Selling?

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Short selling a stock is taking an investment position that will rise in value if the targeted stock falls in price.

Short selling is one of the most widely misunderstood investment tactics. Most investors are “long” a stock, meaning that they have bought the stock on the expectation that the price will go up over time.

If the stock does go up in price, the long investor can sell it and realize a profit. The short seller is taking the opposite point of view. He thinks the stock is overpriced and likely to fall in price soon.

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The short selling investor does not buy but instead borrows the stock in question. He sells the borrowed shares immediately, collects the cash and waits for the price to fall.

Once the price falls he repurchases the same number shares he previously borrowed more cheaply and returns them to the lender. Since it takes less cash to buy the shares back, the short seller has realized a trading profit.

Stock markets don’t go in just one direction. Over long periods of time, of course, the trend is up. But over the short- and medium-term stocks can fall in value.

A shrewd investor might recognize that the current price of a popular stock has gotten ahead of itself. He believes that the stock is ripe for a sharp decline on any negative news.

That’s when short selling comes into play. The pressure of the stock market is broadly upward, but there are legions of doubters, the short sellers, trying to pull shares in the other direction for their benefit.

That yin and yang of the markets is what makes prices efficient and predictable. Over time, it tends to even out for serious investors.

In the short run, though, some short sellers make out like bandits. And some get hung out to dry.

Cash crunch

The risk for short sellers is when brokerages ask for borrowed shares to be returned. If you sold those shares short, now you have to go buy them again to “cover” the loaned shares.

As a result, “short cover” buying sometimes drives up shares that otherwise have no specific news to drive them higher in price.

The other problem is that short sellers can trade on margin, that is, they use borrowed money to make their trades. That can lead to serious cash crunch if a trade you expect to exit on a decline instead rises.

It has been said that short selling is the ultimate get-rich-quick scheme, a way to become infinitely rich with little risk. The fact is, it’s just as easily a get-poor-quick scheme, a way to become infinitely broke in short order, especially if you use margin loans to trade.

Sophisticated financial advisors managing money for the wealthy or institutions sometimes use short selling to reduce portfolio risk or to set up potential tax advantages.

For most investors, however, short selling is nothing but risk with little reward, and should be avoided.

The Shocking Truth About Fake News Headlines

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“I read it on the Internet, it must be real” is likely to go down as the hallmark of this year’s presidential election.

Research suggests that engagement on social media sites, principally Facebook, was far higher for fake news headlines than for real reports from legitimate media sources. According to Buzzfeed News, hoax news stories generated 8.7 million shares, vs. 7.4 million for real journalism.

Whatever side you might have chosen to vote for and for whatever reasons, the upshot is that millions of your fellow citizens probably voted on the basis of utterly made-up “reporting.” A sobering thought.

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All of this will die down in time and the national consciousness will shift toward the holidays, then something else. What’s far less understood, of course, is just how much of what we read online about other topics also is fake.

You don’t have to go too far online, for instance, to find stock touts. These age-old scams use publicity to gin up interest in a single share, usually one that is small and thinly traded.

If enough people bite, the stock goes up — until it all falls apart like a ponzi scheme. By then, of course, the authors of the tout have cashed out.

It’s illegal to do this, but the Internet is completely unpoliceable in reality. People get taken in all the time, especially when reading purported “insider” reports about otherwise worthless little firms that trade over the counter.

Another time-honored scam are “systematic” trading schemes. Sign up for a special report, essentially giving up your email to receive marketing materials, and then watch out!

Your inbox is soon flooded with stock tips, weight-loss pills, super vitamins, all manner of quackery.

If you decide to take the newsletter, you’ll get advice alright. None of it profitable, except for the newsletter author collecting your subscription fee.

You can shield yourself from all of this unnecessary risk by ignoring the niche financial media and just sticking to the mainstream business press. That’s a good first step.

Second, of course, is to avoid stock picking altogether. If you want to own stocks for their inflation-fighting capability, own them through a diversified, low-cost index fund.

For instance, you can buy the S&P 500 for a tiny fraction of the cost of owning a typical actively managed stock mutual fund.

Ignore fake news headlines

Likewise, there are index funds for the broad bond market, real estate, and foreign shares, too, also available at a very low cost.

Once you own 500 stocks, you tend to think less and less about which ones are winning or losing at any given moment in the business cycle. The fake news headlines on TV and blaring at you from the Internet gradually lose meaning.

Sure, the events of the day could affect the value of your investments, but the long run is what matters and research shows that the stock market can go neither too high nor too low with eventually reverting to its mean.

That “mean” is where you want to be, adding in your reinvested dividends and contributions and compounding your money steadily over decades. Then you can just glance at your phone and chuckle at the headlines, rather than worry about them.

Investor Facts: What Is A Large Cap Stock?

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A large cap stock is a stock issued by a company whose market capitalization is much larger than most of the companies traded on the same stock exchange.

Large cap is a phrase used to describe companies with a large market capitalization, the dollar value its traded shares.

Investors use the term large cap to differentiate them from small cap and mid cap stocks. Large cap stocks usually well-established and large industrial, technology, consumer goods and drug companies.

Large cap on the U.S. stock exchanges signifies a market cap of well over $10 billion, though this number changes over time and is subject to interpretation by investment firms.

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It’s important to note that not all companies trade shares on public exchanges and the percentage of shares traded compared to total shares can vary. Thus it can be misleading to use market capitalization to deduce the actual size of any given company.

When investors say they own only “quality” or “blue chip” investments, they often mean that they own mostly large cap stock investments. They think of these investments as being high quality because typically to reach that size a company has to outlast a large number of competitors.

That doesn’t mean a large cap stock cannot lose value or that the company those shares represent cannot go bankrupt. It only means that the company has a longer record of recording successful profits and revenue growth and has a well-established brand or industry niche.

Investors do not expect a large cap stock to grow dramatically in a short period of time. Rather, they count on these investments to deliver steady growth and, in many cases, a strong dividend.

Total return

Dividends are your share of the company profits. Many large cap stock firms find that they cannot reinvest their incoming capital very well. The industry is too crowded or the company is not optimized for research and development.

In that case, the company instead gives cash back to shareholders to reward them for remaining invested in a slower-growing firm or industry. A positive change in the value of the stock added to the dividend is known as total return.

Most big mutual funds own a broad selection of large cap stocks. Likewise, owning an S&P 500 index fund provides exposure to the largest 500 companies in the United States. By design, you own what is essentially a large cap stock fund just by owning the index.

Large cap stock investments are an important part of a prudent long-term retirement portfolio. Owning them through a low-cost stock index fund provides investors with the kind of growth promised by stocks without the riskier effort of trying to choose among them.

How Often Should You Check Your Retirement Fund?

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It’s incredibly easy to keep track of your finances these days. Hundreds of apps on our phones promise to follow spending, investments, budgets and credit cards.

Visit any finance news website and the market tickers are real time. Type in a fund or stock name and you are greeted with an immediate price quote. Even Social Security is on the web now.

You can know anything you want about how your retirement plan is doing, but should you?

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Information alone is not really the answer. In fact, the argument can be made that knowing the minute to minute performance of your investments is more of a danger than not.

Long-term investors eventually grow to understand that the daily, weekly and even quarterly view on their performance can be misleading.

All it takes is one crazy day on the stock market to make your entire investment process seem mistaken. Stocks ebb higher and lower throughout the year, and they tend to overreact to news headlines, moving higher or lower for little reason.

Benjamin Graham, the late dean of stock market investing, often spoke of Mr. Market, a fictional business partner of the investor.

Mr. Market is unable to control his emotions. On a Tuesday, business could not be better and he’d never sell his share of the business to anyone. By Wednesday, his mood has turned and he begs you to take his half at any price.

Naturally, Thursday sees a change of personality once again and he’s back to high spirits. No price is high enough to sell and get out.

Warren Buffett, the iconic billionaire and student of Graham at Columbia University, cites his mentor’s longstanding characterization of the markets this way: “In the short run, the market is a voting machine but in the long run, it is a weighing machine.”

Which is another way of saying: Don’t look. The near-term process of millions of shares being traded back and forth is voting, and voting is noisy. Only when time has passed can we ultimately understand the value of any given investment.

How money grows

The data on that is much clearer. Studies show that stocks with dividends reinvested return about double the inflation rate over long periods of time.

Compounding that money in tax-advantaged retirement accounts using low-cost index funds is how your money will grow.

Paying attention to the actual dollar amount any given day or week is Mr. Market behavior and can lead to all kinds of emotional decisions one is likely to regret. Remember, selling at a bottom locks in losses forever.

How often should you check your retirement fund? Quarterly is a good idea, perhaps even twice a year. You should be looking for opportunities to rebalance, not get in or out of entire categories of investments on a whim.

A steady hand at the rudder keeps the ship on course, allowing your investments to grow and compound the way that they should. Anything less is asking the opinion of Mr. Market, and perhaps on a bad day to be asking.

Investor Facts: What Is A Small Cap Stock?

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A small cap stock is a stock issued by a company whose market capitalization is much smaller than that of the largest companies traded on the same stock exchange.

Small cap is a phrase used to describe companies with a small market capitalization, the dollar value its traded shares. Investors use the term small cap to differentiate them from large capitalization stocks, usually well-established and large industrial, technology, consumer goods and drug companies.

Small cap typically signifies a market cap of between a few hundred million and $2 billion, although the range varies according to which investment firm you consult. Large cap firms tend to start at $10 billion in outstanding share value, while mid-cap falls between the two.

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It’s important to note that not all companies trade shares on public exchanges and the percentage of shares traded compared to total shares can vary. Thus it can be misleading to use market capitalization to deduce the actual size of any given company.

Small cap stock investing is best considered as an important part of a diversified portfolio approach. Accordingly, small cap stocks are usually younger companies and more volatile than their large cap cousins.

Investors buy small cap stocks precisely because the lion’s share of growth is still available to outside investors who buy these companies early in their growth cycle. A small company can double or triple sales and earnings in a short period of time; a large company typically cannot.

Nevertheless, the risks of stock investing are magnified in the small cap universe of stocks. Think about how many companies were in the car business in the early years of the last century. By the end, there were only three.

The rest were put out of business or eaten up by the Big Three in Detroit. A similar trend occurs in nearly every new industry — computers, energy, technology, you name it. A large number of startups yields a busy small cap stock grouping which eventually matures into only the largest and most successful name brands.

A better approach

It’s very hard to pick stocks, even when you think you know something about them. Factors that you cannot understand nor control can wipe out a small company overnight.

Sometimes, small companies launch too early. Their ideas are recognized and rewarded by the market decades later, if it all. Wait too long, however, and you might own a great company whose all-time-high in terms of share price has come and gone.

That’s why index funds are the better approach to small cap stock investing. Owning small cap stocks in a broad, low-cost index product gives you exposure to the advantages of small cap stocks without necessarily increasing the risk of picking the wrong ones.

Long-term investors use small cap stocks to increase the overall growth potential of a portfolio and rebalance periodically to capture that growth while it exists, year after year.

As the investor who owns the portfolio ages, growth becomes less of a priority and small cap stock investing a subsequently becomes a smaller slice of the investment pie.

Should You Buy Emerging Markets Stock Now?

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A few years ago, the conventional wisdom was that investors should buy emerging market stocks. After all, some said, the demographic future of the world is found in young countries.

Emerging nations would grow into developed ones, and their relatively young citizens would become property owners and productive workers. Buy in and stay in was the argument.

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Then things went south. In some cases, way south. Political disruption, falling oil prices, you name it. A lot of people began to regret the risk they took on countries such as Brazil and Russia, to name just two.

Guess what? The pundits are back and they say it’s time to head abroad, once again.

So where they wrong before? Right? How can the prudent, long-term investor make sense of the risk inherent in foreign stocks, and especially emerging market stocks?

Here are a few rules of thumb retirement investors need to consider when looking at emerging market stocks:

1. Do I need this money in the next five years?

You probably shouldn’t buy any stock with the idea of selling it within five years. Trading is a loser’s game, fraught with timing risk.

The best way to own stock is with an eye toward letting it run its course over more than a few years, and the longer the better. If you need cash in 12 or 24 months for some reason, don’t invest it in stocks on the expectation of stocks going only up.

2. Do I have other investments with similar risk characteristics?

Emerging market stocks are more volatile than most other investments. They will move up and down in price more quickly than, say, large-cap U.S. stocks.

If you already own a lot of volatile small-cap stocks, adding emerging market stocks to the mix will increase the volatility of your portfolio. Perhaps that’s not a problem for you, but it might be.

3. Can I ignore the “news” for long periods?

You can find a pundit somewhere who agrees with your personal conclusions on investing. Finance experts call this “confirmation bias” — the belief that you are right soon leads you to seek evidence of your own opinions.

The long-term investor is better served by simply ignoring the headlines and especially ignoring the public opinions of professional investors. You are not their client, and their scattershot viewpoints are likely to do you more harm then good.

4. Are my domestic alternatives any different?

You’ve probably heard the argument that owning U.S. stocks is the same as owning foreign stocks, since big global food and drug companies earn so much money abroad.

While generally true, it’s unlikely that true emerging market earnings are a big piece of that pie. Meanwhile, stocks in developed foreign countries are not the same as emerging markets stocks at all.

Rather, developed foreign countries are more like the United States than not — home to big global names of their own.

5. What is my actual time horizon?

This is a biggie. If you are not planning to retire for decades, the volatility of emerging market stocks is much more friend than enemy. Rebalancing a portfolio will allow you to buy into slower periods while emerging stocks are cheaper.

When emerging stocks peak, you get to take money off the table to reinvest in other parts of your portfolio. Steady rebalancing means no marketing timing is needed.

If you expect to retire in less than five years, first consider how much volatility you can stand. Consider, too, that some portion of your retirement savings needs to grow for the years to come, should you enjoy a longer retirement than most.

Investor Facts: What Is Inflation Risk?

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inflation risk

Inflation risk is the risk that an investment will not grow fast enough to offset the lost purchasing power of your invested cash.

Inflation is the rising cost of goods and services that makes up what we commonly call the cost of living.

A broad but manageable increase in inflation over the years is considered a sign that the economy is in good shape. It means incomes are rising as well, which leads to spending and emboldens producers to raise prices accordingly.

Inflation can get out of hand, however. That’s why the U.S. Federal Reserve watches prices carefully, hoping to steer the economy toward growth without risking too much inflation. It’s also why we use investments in stocks, bonds and other assets to increase our unspent cash.

Inflation risk is just one factor among many in evaluating an investment, but it can be an important one.

For instance, if a bond pays a return that is at or near the current inflation rate, you have protected the value of your cash but you have not increased your wealth. That might be a reasonable result if other risks you take on the bond are very low, such as the risk the bond might default.

Comparatively, a stock that that fails to keep up with inflation is perhaps a poor investment. Most investors buy stocks precisely because historically they grow faster than the inflation rate.

Inflation risk is just one of several risks that are inherent in investing. For instance, a company issuing stock could declare bankruptcy. A bond-issuing company or government might default on the bond.

There are also a variety of risks that come from simple human reactions to investing. Any investment can be sold too early or too late, for instance. It’s far too easy to allow our emotions to take over or to let our perception of an investment become more important than facts.

Beyond inflation risk

Still another risk is failing to invest at all. Far too often, young investors put their hard-earned cash into retirement accounts and then sit on it, waiting for the right time to invest.

Money should grow and compounds over decades. When you’re 70, it won’t matter if you bought your first stock at age 22 or 23. In fact, you should be investing steadily with each paycheck regardless of the position of the stock market.

Steady investing of your cash means you are buying away inflation risk by being invested in the first place. If you’re worried about selecting the “right” investments, then use a broad stock mutual fund instead.

For most people, the most cost-effective way is to own an index fund that tracks either the S&P 500 or the whole stock market.

Inflation risk is diminished simply by owning effective inflation-beating investments, mostly stock investments. Diversification reduces the emotional risk of selling or buying at inopportune times.

As you invest over the years, that value of your cash should greatly exceed inflation thanks to the magic of compounding. The trick is to start early, invest consistently and to stick to a long-term plan.

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