Money Market Advice
The money market refers to a class of low-risk and low-reward, interest-bearing investments. Money market securities are therefore logical savings vehicles to help you build toward intermediate goals, such as a wedding or home remodeling project. Money market investment performance correlates directly to the prevailing interest rate environment. Learn to monitor Federal Reserve Board policy before making your own investment decisions.
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Misconceptions
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Money market deposit accounts are distinct from money market securities. The Federal Deposit Insurance Company (FDIC) guarantees bank-offered money market deposit accounts. As of 2010, the FDIC backs $250,000 worth of deposits per customer, per insured bank. FDIC coverage, however, does not apply to money market securities.
Money market mutual funds make investments into the money market. Money market deposit accounts, however, are not necessarily invested into the money market.
Identification
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Money market securities are debt obligations that mature in less than one year. As a money market investor, you are actually loaning money out to a corporate or government entity. For returns, you collect interest payments until your loan is repaid at its maturity date. Individual money market securities include U.S. Treasury bills and commercial paper. Smaller investors typically access the money market through money market funds.
Because of their short durations, money market assets feature low financial risks. For example, Corporation X is more likely to remain viable and pay interest on money market debt due in one month than it is to avoid bankruptcy and pay bond interest over the next decade. In exchange for money market safety, you must accept relatively minimal returns.
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Considerations
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Money market interest rates are highly sensitive to the federal funds rate. Banks loan money to each other overnight at the federal funds rate--so that each financial institution can meet its Federal Reserve requirements. The federal funds rate is a benchmark, or comparison standard, for all interest rates.
In recession, you can expect to earn minimal interest rates and returns on money market assets when the Federal Reserve lowers interest rates. Reduced borrowing costs encourage people to take out loans and invest money amid recession. Ultimately, the increased commercial activity supports a stronger economy. When the economy recovers and performs well, the Fed targets higher interest rates to protect against inflation. At that point, you will earn higher returns on money market securities.
Warning
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Money market assets are susceptible to both inflation and opportunity cost risks. Inflation relates to increasing prices for goods and lost purchasing power. For example, your real returns are negative when you earn 1 percent annually on money market assets, while domestic inflation runs at a 3 percent clip. Meanwhile, opportunity costs describe foregone profits from competing investments. Money market investments are much less attractive when stocks post strong gains.
Strategy
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Investment diversification allows you to manage risks and exploit opportunities for growth. A diversified portfolio may include money market securities, bonds and stocks. In a recession, the money market and bond assets generate interest income to buffer your portfolio against losses. Amid a strong economy, your stocks should perform well.
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References
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