In this article
- How money markets work
- The advantages of money market investments
- Balancing safety against potentially higher returns
- Short-term cash needs and diversification
When you begin to build a portfolio of investments, you need to consider your short-term goals as well as your long-term goals. For example, do you plan to take a vacation or buy a car during the next year? You must also think about what portion of your portfolio will need to be liquid, or easily accessible, in case of emergencies. In addition, consider how much relative stability your portfolio will need to allow you to feel comfortable as you pursue your long-term goals.
How money markets work
Money market mutual funds can serve short-term and emergency cash needs, as well as provide an element of relative stability to help diversify your portfolio. Keep in mind that an investment in a money market fund is neither insured nor guaranteed by the U.S. government, and there can be no guarantee that the fund will maintain a stable $1 share price. It is possible to lose money by investing in the fund.
Some investors believe that money market mutual funds invest in stocks. In fact, they do not. Money market funds invest in short-term debt instruments purchased on what's known as the "money market."
The money market is not a particular place, but rather how the U.S. government, banks, corporations, and other large institutions manage their short-term cash needs.
Example. When the U.S. government needs money quickly, it borrows from the money market by issuing Treasury bills (T-bills) that institutions and extremely wealthy individuals will purchase. The T-bills represent the government's promise to pay back the loan.** These investments mature, or come due, in short periods of time, when the government repays the loan.
Similarly, banks will offer short-term debt instruments called certificates of deposit,*** and corporations will offer commercial paper. Other securities traded on the money market include repurchase agreements, banker's acceptances, and government-agency obligations. Money market investments also include short-term tax-exempt issues from municipalities and maturing municipal bonds.
**Keep in mind that U.S. Treasury bills/U.S. government bonds are guaranteed as to principal and interest payments (although the funds that invest in them are not). However, the returns of U.S. Treasury bills/U.S. government bonds historically have not outpaced inflation by as great a margin as stocks, although past performance cannot guarantee future results.
***CDs offer a guaranteed rate of return, guaranteed principal and interest, and are generally insured by the Federal Deposit Insurance Corp. (FDIC), but do not necessarily protect against the rising cost of living.
High credit quality, short maturity and relatively low risk
Money market investments generally have a high credit quality, which means that there is little risk that their issuers will not be able to repay their debt. Because of this high quality, they are considered low-risk investments. Money market mutual funds pool these securities in one investment vehicle that brings low-risk opportunities to the everyday investor.
How Money Market Funds Seek To Maintain A Stable Net Asset Value
Money market funds strive to maintain a reputation for safety by keeping the value of each fund share constant at $1. To achieve this, money market fund portfolio managers plan to hold each security they purchase until maturity, when the full principal is repaid by the issuer. If a portfolio manager has to sell a security before it matures, he or she runs the risk that it will have declined in value, either due to a general increase in interest rates or a decline in the credit quality of the issuer.
In addition, the securities held within a money market fund have short maturities, usually one year or less. These short maturities result in a low sensitivity to interest rates. In other words, as long as the fund can hold its securities to maturity, the value of the fund will not fluctuate due to changes in interest rates.
Because of their low-risk holdings and their low susceptibility to changes in interest rates, money market mutual funds are able to offer shares at the net asset value of $1 -- and can strive to maintain this stable value, with the goal of reducing risk.*
Liquidity, competitive rates, low fees and more
In addition to providing stability and low risk, money market funds may offer the following benefits:
Money markets do not require you to invest your money for set amounts of time. You can withdraw your money whenever you need it, without penalty. Other short-term, stable investments are not as liquid.
Because fund management is not as complex as it can be for other types of mutual funds, these funds can charge lower fees and expenses.
Dividends are credited to your account daily, which helps to ensure that your earnings are always up to date and available.
Lower minimum investments
Money market mutual funds generally offer lower initial investment minimums than other investments.
Many money market funds allow you to write checks against the balance, although there can be limits on this privilege.
Competitive interest rates
During a high-interest-rate environment, money market mutual funds seek competitive yields providing the potential for solid returns.
Money market funds: for cash and diversification
Within an investor's portfolio, money market funds can serve two main purposes: short-term cash needs and diversification.
Short-term cash needs
You can redeem shares of your money market funds for short-term savings and cash needs.
- Larger-ticket expenses you will have over the next year, such as that new car or vacation.
- Retirees often find money market funds to be appropriate vehicles for managing current income and cash needs, and for cash needs one to three years distant.
- Higher income-earners may want to consider tax-exempt money market funds.
Money market funds can help bring stability to a portfolio heavily weighted in riskier stock and bond investments.
While money market funds help with short-term needs and diversification strategies, investors should remember that they are, certainly, conservative investments. Investing your portfolio too heavily in money market funds can hurt its potential for long-term growth. Investors who are primarily seeking high long-term returns may be better served by investing only a minority of their portfolio in money market funds.
Because potential money market returns tend to just keep pace with inflation before taking taxes into account, money set aside in money market mutual funds can actually lose purchasing power after income taxes on annual returns are factored in.
Shop wisely: interest rates affect growth
Also, investors need to evaluate the short-term interest rate environment before they choose money market funds. While such funds respond quickly and positively to rising short-term rates, the same holds true for rate declines. In a low-interest-rate environment, investors will need to shop around to find the best returns for their short-term needs.
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Please be advised that this materials is not intended as legal or tax advice. Accordingly, any tax information provided in this material is not intended or written to be used, and cannot be used, by any taxpayer for the purpose of avoiding penalties that may be imposed on the taxpayer. The tax information was written to support the promotion or marketing of the transactions(s) or matter(s) addressed and you should seek advice based on your particular circumstances from an independent advisor.
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