When investors think about the capital markets, they typically ponder the merits of bonds, stocks or derivatives. Because it isn't as sexy and doesn't have the volatility of other securities, the money market is often far from the top of the list. Nevertheless, virtually all investors can use the money market to enhance their portfolios in one way or another. In this article, we'll explain how investors can use the dependability of the money market to their advantage.
What Is It?
The money market is a market that provides liquidity for individuals and institutions by dealing in short-term borrowing such as certificates of deposit, T-bills or other similar instruments with a maturity date of about one year or less. With that in mind, because the vehicles used in the money market are relatively safe when compared to their equity and debt counterparts, and are often backed by the full faith and credit of the U.S. government (such as with T-bills), the rate of return on a money market account is in the low single digits.
In spite of the relatively low returns, the money market can be a great way for investors to preserve, and even make, a little bit of money. Just think about this scenario: suppose that you have recently bailed out of a stock, but you haven't yet decided where to invest the proceeds. In this case, the money market can provide a relative safe haven for that capital by offering an annualized return of around 3- 4% without having to absorb any real risk.
The money market is also a useful hedge against market declines. Suppose an investor is bearish on the outlook for the stock or the bond market. This investor could liquidate his account and opt to receive a check for the proceeds. Or, he may weather the storm while earning single-digit returns in the money market. In fact, the money market is where the big investment banks keep their funds in between deals, and where municipalities often invest proceeds from debt offerings while waiting to put the money to use in a project. (For more insight, see A Beginner's Guide To Hedging.)
Perhaps the biggest advantage and the most attractive feature of the money market is liquidity. That is because there are countless entities looking to invest their capital in between investments, or as a hedge. This means that if an investor wants to liquidate a money market position, he or she will have very little trouble turning the funds into cash. This comes in handy if you need to write a check against the account. In fact, most brokerage firms and mutual funds will give their clients a book of checks when they open their accounts. Talk about convenient!
There are risks in every investment, but the money market is probably one of the safest places for your capital. After all, the funds are invested in relatively secure government or other short-term, high-quality debt. Usually, the real risk represents an opportunity cost. In other words, the risk that the funds invested in a money market account could have fared better in a different investment vehicle such as a stock or a bond. Also keep in mind that money market funds can sometimes fail to keep pace with inflation. This means that an investor's purchasing power may decline each year even if that investor is fully invested. For this reason, it rarely makes sense to put all of your funds into the money market for an extended period of time. (For related reading, see All About Inflation.)
How can you get involved? Most brokerage houses will give investors the option of "sweeping" proceeds from a stock or bond sale into a money market account so that they may earn interest while their money is in limbo.
The only real disadvantage is that money market income will likely be taxed as a short-term capital gain, which means that you may owe the Internal Revenue Service a larger amount than if you were able to hold the securities for more than a year. (To learn more, see A Long-Term Mindset Meets Dreaded Capital Gains Tax.)
A taxable event can be avoided by buying into tax exempt money market funds. In this case, you would invest your capital in municipal notes. The income from these notes, if you live in the state in which they are originated, is often exempt from federal, state and local taxes. This means that the actual return, because of the tax advantages, may be much better then the taxable investment you might have considered as an alternative. (For more insight, read Avoid Tricky Tax Issues On Municipal Bonds.)
While the money market probably won't make you rich - it may not even outpace inflation by a large margin - it is a great place to park money while waiting for other investment opportunities to come to fruition, and for hedging a percentage of your portfolio against a market decline.