Money market accounts serve the useful purpose of keeping our money safe and liquid, but they are often misunderstood and misused. These are the five biggest mistakes people make when it comes to money market accounts.
1. Confusing a Money Market Account with a Money Market Fund
Mistaking a money market account for a money market fund is a common error, but there are critical distinctions between the two financial instruments.
Money market accounts are deposit accounts held at banks, which have their principal protected up to $250,000 by the Federal Deposit Insurance Corp. (FDIC). These accounts offer similar benefits to savings accounts. However, a money market account requires that a minimum balance is held in the account for a designated period, usually around a year. Money market accounts invest in low-risk, stable funds like Treasury bonds and typically will pay higher rates of interest than a savings account. In contrast, a money market fund is a mutual fund characterized by low-risk, low-return investments. Getting in and out of an MM fund is relatively easy, as there are no loads associated with the positions.
Often, though, investors will hear “money market” and assume their money is perfectly secure – this does not hold true with money market funds. These types of accounts are still an investment product, and as such have no FDIC guarantee.
2. Not Thinking About Inflation
A common misconception is believing that placing money in a money market account will safeguard you against inflation. While the inflation rate is low in 2017, (the 20-year historical average inflation rate is 2.24%), and a typical money market account pays well under 2% interest. Therefore, money sitting in a money market account is not likely to outpace inflation.
Many argue that it is better to earn the small interest in a bank rather than earn no interest at all, but outpacing inflation in the long term is not what a money market account is really for. Let’s assume, for example, that inflation is lower than the 20-year historical average. Even in this situation, the interest rates that banks will pay on these types of accounts will decrease as well, thus affecting the original intent of the account to begin with. Thus, while money market accounts are safe investments, they will not safeguard you from inflation.
3. Keeping Too Much In It
The changing rates of inflation can influence the efficacy of money market accounts. In short, having a high percentage of your capital in these accounts is inefficient. Typically, 6-12 months of living expenses are the recommendation for the amount of money that should be kept in cash in these types of accounts for unforeseen emergencies and life events. Beyond that, the money is essentially sitting and losing its value.
4. Using Money as an Emotional Safety Blanket
In many instances, we are programmed to believe that hoarding money is the most fruitful approach. When it comes to money market accounts and keeping money in standard savings accounts, that does not hold true. It is difficult to have money that you have worked hard for thrust into the open market and all the uncertainty that comes with it. Unfortunately, people often stay put in their cash positions for too long instead of investing it – because of fear.
The Great Recession only led already weary investors further into the cash-hoarding rabbit hole; however, high-yield returns on your money can only come from diverse investments. Fifty years ago, you could stow money away little by little each day and be confident you would be okay, but modern times dictate a far different future for our financial stability. Today, the challenge is to outsmart our natural reflex to hold all of it.
5. Not Dividing It Up
The diversification of assets is one of the fundamental “laws” of investing. Cash is no different. If you insist on holding all of your money in money market accounts, no one account should hold more than the FDIC-insured amount of $250,000. It is not uncommon to see families or estates with tens of bank accounts to insure their money as much as possible. Within this strategy, dividing the money up into three “buckets” can prove useful. Having money set aside for the short-term (1-3 years) medium-term (4-10 years) and long-term (10 years plus) can lead investors down a more logical approach to how long, and how much, money has to be saved. To take a more tactical approach, we can apply the same “buckets” and assess your tolerance for risk in a realistic way.
Consider putting long-term money into other low-risk investment vehicles like an annuity, life insurance policy, bonds, or Treasury bonds. There are countless options to divide your net worth to hedge the risk of losing the value of your money kept in cash. Several investment vehicles aside from money markets accounts offer higher interest. For more tolerant investors, or those who wants to keep some money moving for the short and medium terms, there are funds and investment strategies that can provide the returns which you seek – given time and your stomach for volatility. These approaches, keeping money constantly moving for each period of your life, can help to outpace current and future inflation while protecting money from losing its value. Either way, being keen on the full understanding of these products is what will allow you to make the right decision for yourself.
The Bottom Line
Money market accounts serve a singular purpose – to keep your money parked. Money, though, does nothing unless it is moved, and will ultimately require the investor to research their options and invest more diversely.