Money Market Funds: Risk to Reward
- Money market mutual funds are investment pools that own money market securities. Money market investments are debt securities that mature in less than one year. These investments include U.S. treasuries, certificates of deposit, and commercial paper. Institutions use the money market to raise short-term financing from investors. In exchange, investors earn interest, until the loan principal is repaid.
- Money market mutual funds rarely lose value, and these assets offer a high level of liquidity. Liquidity refers to the ease of which a particular asset is converted back into cash. Investors are willing to accept lower rates of return from money market securities because of their safety. Money market securities offer far less profit potential than stocks, bonds, real estate, and private business investments. Money market funds hold value and make small interest payments, while competing assets may create long-term wealth through capital gains. Capital gains describe the differential between your purchase and sales prices for investments.
- In the United States, the Federal Reserve manages prevailing interest rates with monetary policy. Lower rates encourage people to borrow money to make investment commitments and purchase durable goods. Conversely, higher interest rates discourage these activities. The Fed raises rates to slow down the economy when inflation is a concern.
The Fed targets an interest rate for its overnight lending rate to implement monetary policy. The overnight lending rate is the interest that banks charge one another overnight to meet their reserve requirements at the Federal Reserve Board. Because of their short maturities, interest rates paid on money market securities track the Fed's overnight lending rate closely. This relationship significantly reduces interest rate risks. Interest rate risks arrive when prevailing interest rates rise, while you are holding a long-term fixed-income investment. For example, existing 30-year treasury bonds suffer sharp losses in value when interest rates increase. At that point, investors covet newly issued bonds for higher interest payments. - Do not mistake money market funds for money market deposit accounts. Money market deposit accounts are offered by banks and carry FDIC insurance to guarantee your savings. The FDIC does not back money market mutual funds.
- Money market mutual funds expose you to inflation and opportunity cost risks. Inflation refers to the loss of long-term purchasing power from rising price levels. Small interest payments earned from money market funds may not keep pace with inflation. Further, opportunity costs risks describe foregone profits from competing investments. Money market returns are even less attractive when the stock market performs well.
