The Pros And Cons Of Money Market Funds
Money market investing carries a low single-digit return, and when compared to stocks or corporate debt issues, the risk to principal is generally quite low. However, there are a number of positives and negatives that all investors should be aware of when it comes to the money market. In this article, we'll take a look at these ups and downs, and show you how the downs can greatly outweigh the ups. (To learn about money market basics, see Introduction To Money Market Mutual Funds.)
TUTORIAL: Investing In The Money Market
When the stock market is extremely volatile and investors aren't sure where to invest their money, the money market can be a terrific safe haven. Why? As stated above, money market accounts and funds are often considered to have less risk than their stock and bond counterparts. That is because these types of funds typically invest in low-risk vehicles such as certificates of deposit (CDs), Treasury bills (T-bills) and short-term commercial paper. In addition, the money market often generates a low single-digit return for investors, which in a down market can still be quite attractive. (To learn more about investing in market downturns, see Recession-Proof Your Portfolio.)
2. Liquidity Isn't Usually an Issue
Money market funds don't generally invest in securities that trade minuscule volumes or that tend to have little following. Rather, they generally trade in entities and/or securities that are in fairly high demand (such as T-bills). This means that they tend to be more liquid, and that investors can buy into them and sell them with comparative ease.
Contrast this to, say, shares of a mid-cap biotech company. In some cases those shares may be highly liquid, but in most the audience is probably very limited. This means that getting into and out of such an investment could be difficult if the market were in a tailspin.
1. Purchasing Power Can Suffer
If an investor is generating a 3% return in their money market account, but inflation is humming along at 4%, the investor is essentially losing purchasing power each year. Over time, money market investing can actually make a person poorer in the sense that the dollars they earn may not keep pace with the rising cost of living.
2. Expenses Can Take a Toll
When investors are earning 2% or 3% in a money market account, even small annual fees can eat up a substantial chunk of the profit. This may make it even more difficult for money market investors to keep pace with inflation.
Depending on the account or fund, fees can vary in their negative impact on returns. If, for example, an individual maintains $5,000 in a money market account that yields 3% annually with his or her broker, and the individual is charged $30 in fees, the total return can be impacted quite dramatically.
- $5,000 x 3% = $150 total yield
- $150 - $30 in fees = $120 profit
3. FDIC Insurance Net May Not Be There
Money funds purchased at a bank are typically insured by the Federal Deposit Insurance Corporation (FDIC) for up to $100,000 per depositor, according to Care One Credit Counseling. However, money market mutual funds are not usually government insured. This means that although money market mutual funds may still be considered a comparatively safe place to invest money, there is still an element of risk that all investors should be aware of. (To learn more, read Are My Investments Insured Against Loss?)
If an investor were to maintain a $20,000 money market account with a bank and the bank were to go belly up, the investor would likely be made whole again through this insurance coverage. Conversely, if a fund were to do the same thing, the investor may not be made whole again - at least not by the federal government.
4. Returns May Vary
While money market funds generally invest in government securities and other vehicles that are considered comparatively safe, they may also take some risks in order to obtain higher yields for their investors. So, in order to try to capture another tenth of a percentage point of return, it may invest in bonds or commercial paper that carry additional risk.
The point is that investing in the highest-yielding money market fund may not always be the smartest idea given the additional risk. Remember, the return a fund has posted in a previous year is not necessarily an indication of what it may generate in a future year.
It's also important to note that the alternative to the money market may not be desirable in some market situations either. For example, having dividends or proceeds from a stock sale sent directly to you (the investor) may not allow you to capture the same rate of return. In addition, reinvesting dividends in equities may only exacerbate return problems in a down market.
Over time, common stocks have returned about 8-10% on average - counting recessionary periods. By investing in a money market mutual fund, which may often yield just 2% or 3%, the investor may be missing out on an opportunity for a better rate of return. This can have a tremendous impact on an individual's ability to build wealth.
The Bottom Line
Money market investing can be a very advantageous thing to do. However, before investing any money in a money market mutual fund, investors should first understand both the pros and the cons. Depending on your individual investment and where the market is heading, these accounts could make or break your retirement.