There are a number of pros and cons investors should be aware of when it comes to money market funds. In this article, we will look at these ups and downs.
Money Market Funds – Overview
Investing in the money market has a low single digit return. Compared to stocks or corporate debt issues, the risk to equity is generally quite low. However, investors must weigh a number of pros and cons. Casualties can outweigh highs.
Advantages of money market funds
First, let’s consider the benefits of putting your money in a money market account.
Great place to park money
When the stock market is extremely volatile and investors are unsure where to invest their money, the money market can be an excellent safe haven. Why? As noted above, money market accounts and funds are often viewed as having less risk than their stock and bond counterparts. This is because these types of funds typically invest in low-risk vehicles, such as certificates of deposit (CDs), Treasury bills (Treasury bills), and short-term commercial paper. In addition, the money market often generates low single-digit returns for investors, which in a falling market can be quite attractive.
Liquidity is not usually a problem
Money market funds generally do not invest in securities that trade miniscule volumes or tend to have few followers. On the contrary, they mainly negotiate with entities and / or securities that have a fairly high demand (such as Treasury bills). This means that they tend to be more liquid; investors can buy and sell them relatively easily. Compare this to, for example, the stock of a small-cap Chinese biotech company. In some cases, those stocks can be very liquid, but for most, the audience is likely to be very limited. This means that getting in and out of such an investment could be difficult if the market were in a tailspin.
Over time, investing in the money market can actually make a person poorer in the sense that the dollars they earn may not keep up with the rising cost of living.
The Pros and Cons of Money Market Funds
Disadvantages of money market funds
Now let’s talk about the downsides of having your funds in a money market account.
Purchasing power can suffer
If an investor is generating a 3% return on their money market account, but inflation remains at 4%, the investor is essentially losing purchasing power each year.
Expenses can take their toll
When investors get 2% or 3% on a money market account, even small annual fees can eat up a substantial portion of the profits. This can make it even more difficult for money market investors to keep up with inflation. Depending on the account or fund, fees may vary in their negative impact on profitability. If, for example, a person keeps $ 5,000 in a money market account that yields 3% per year, and is charged $ 30 in fees, the total return can be dramatically affected.
- $ 5,000 x 3% = $ 150 total return
- $ 150 – $ 30 in fees = $ 120 profit
The $ 30 in commissions represents 20% of the total return, a large deduction that reduces the bottom line considerably. The above amount also does not take into account the tax obligations that may arise if the transaction is carried out outside of a retirement account.
FDIC Safety Net May Not Be There
Money funds purchased from a bank are generally insured by the Federal Deposit Insurance Corporation (FDIC) for up to $ 250,000 per depositor. However, money market mutual funds are not usually insured by the government. This means that while money market mutual funds can still be considered a comparatively safe place to invest money, there is still an element of risk that all investors should be aware of. If an investor were to maintain a $ 20,000 money market account with a bank and the bank collapsed, the investor is likely to recover again through this insurance coverage. On the contrary, if a fund were to do the same, the investor may not recover again, at least not by the federal government.
The 2008 financial crisis dull the stellar reputation of money market funds. A large money market bottom broke the ball (stocks fell below $ 1.00), causing a run across the money market industry. Since then, the industry has worked with the Securities and Exchange Commission (SEC) to introduce stress tests and other measures to increase resilience and repair some of the reputational damage.
Returns may vary
While money market funds generally invest in government securities and other vehicles that are considered comparatively safe, they can also take some risks to earn higher returns for their investors. For example, to try to capture another tenth of a percentage point of return, the fund may invest in bonds or commercial paper that carry additional risk. The point is, investing in the highest-yielding money market fund may not always be the smartest idea given the added risk. Remember, the performance a fund has posted in a previous year is not necessarily an indication of what it can deliver in a future year.
It is also important to note that the money market alternative may also not be desirable in some market situations. For example, receiving dividends or proceeds from a sale of shares directly to you (the investor) may not allow you to obtain the same rate of return. Also, reinvesting dividends in stocks can only exacerbate profitability problems in a declining market.
Over time, common stocks have returned 8-10% on average, including periods of recession. By investing in a money market mutual fund, which can often yield only 2% or 3%, the investor may be missing out on a better rate of return. This can have a tremendous impact on a person’s ability to build wealth. (For related reading, see “CPFXX, SPAXX, VMFXX: Top Government Money Market Funds”)
- Investing in the money market can be very advantageous, especially if you need a relatively safe short-term place to park cash.
- Some downsides are low returns, loss of purchasing power, and that some money market investments are not FDIC insured.
- Like any investment, the above pros and cons make a money market fund ideal in some situations and potentially damaging in others. If you are 30 years old and you keep your retirement savings in a money market fund, for example, you are probably doing the wrong thing.