Investing can be a risky endeavor. There are many different factors you have to consider before making a commitment to any investment vehicle. If you invest in stocks, you have to bear the risk of market and economic volatility. Bonds carry with them both interest rate and inflationary risks. But if you're in the market for something that is fairly safe, there's always the money market account.
Money market accounts serve the useful purpose of keeping our money safe and liquid. But they are often misunderstood and misused. But what are they? And how do you avoid some of the mistakes most people make when they invest in these low-interest bearing vehicles?
Read on to find out about the five biggest mistakes investors make when it comes to money market accounts.
- Money market accounts are like regular savings accounts with distinct features that set them apart.
- Investors must hold a minimum balance for a specified period of time and are limited to the number of transactions allowed.
- Money market accounts are not money market funds, which are like mutual funds.
- These accounts are also prone to inflationary risk, and should not be used as the prime source of investment.
What Are Money Market Accounts?
First, it's important to understand these accounts and what they offer. Money market accounts are deposit accounts held at banks and credit unions. Often referred to as money market deposit accounts (MMDA), they often come with features that make them distinct from other savings accounts. They are considered a great place to hold your money temporarily, especially when the market is raging with volatility and you can't be sure of any other safe haven.
When you hold a money market account, you can be certain your balance is insured by balance the Federal Deposit Insurance Corporation (FDIC) up to $250,000. There is typically a required minimum balance. An investor whose balance falls below the minimum usually incurs a fee.
Many MM accounts come with check-writing ability and a debit card. But an investor has a limited amount of transactions—a total of six transfers and electronic payments per month, as per the Federal Reserve Regulation D. Fees are imposed on consumers who make more than the prescribed limit.
These accounts are interest-bearing—generally single-digit returns—and may pay a little more than a traditional savings account. That's because they can invest in low-risk, stable funds like Treasury bonds (T-bonds) and typically pay higher rates of interest than a savings account. While the returns may not be not much, money market accounts are still a pretty good choice during times of uncertainty.
They Aren't Money Market Funds
Mistaking a money market account for a money market fund is common, but there are critical distinctions between the two financial instruments.
A money market fund is a mutual fund characterized by low-risk, low-return investments. These funds invest in very liquid assets such as cash and cash equivalent securities. They generally also invest in high credit rating debt-based securities that mature in the short term. 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. But 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.
Money market fund returns depend on market interest rates. They may be classified into different types such as prime money funds which invest in floating-rate debt and commercial paper of non-Treasury assets, or Treasury funds which invest in standard U.S. Treasury-issued debt like bills, bonds, and notes.
A common misconception is believing that placing money in a money market account safeguards you against inflation. But that's not necessarily true.
Many argue it is better to earn small interest in a bank rather than earn no interest at all, but outpacing inflation in the long term is not really the point of a money market account. The inflation rate was low in 2020—1.36% as of December, while the 20-year historical average inflation rate is 2.1%. Meanwhile, the average money market account pays under .60% interest. Therefore, money sitting in a money market account is not likely to outpace inflation.
Let’s assume, for example, that inflation is lower than the 20-year historical average. Even in this situation, the interest rates banks pay on these accounts decrease as well, affecting the original intent of the account. So while money market accounts are safe investments, they really don't safeguard you from inflation.
Investing in a money market account does not safeguard you from inflation.
Just the Right Balance
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. But they do require a larger minimum balance than traditional savings accounts.
Six to 12 months of living expenses are typically recommended 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.
Money as a Safety Blanket
In many instances, we are programmed to believe that hoarding money is the most fruitful approach. But that's not necessarily true, especially when it comes to saving money in money market or standard savings accounts. It is difficult to have money that you have worked hard for a thrust into the open market, exposed to all the uncertainty that comes with it. Unfortunately, people often stay put in their cash positions for too long instead of investing them, and that's all because of fear.
The Great Recession only led already wary investors further into the cash-hoarding rabbit hole. But 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.
Divide it Up
The diversification of assets is one of the fundamental laws of investing. Cash is no different. If you insist on holding all 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 multiple bank accounts insuring their money as much as possible.
Using this strategy, dividing the money up into three “buckets” can prove useful. Having money set aside for the short-term (one to three years), the mid-term (four to 10 years, and the 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 market accounts offer higher interest. For more tolerant investors or those who want 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, along with 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.