As an investor, you may be willing to accept a lower rate of return in exchange for a degree of safety. To shelter yourself from the volatility of the stock market , you may choose to hold at least a part of your portfolio in the money market. But the risk-reward tradeoff also applies in the money market. The yield spread – the percentage difference between the returns on different investments – is an indication of the risk premium.
Your money market investments are subject to three types of risk : market risk, interest-rate risk and inflation risk. Events in the financial markets, especially unexpected changes, can affect the value of your investment. Or your creditor institution could default . Interest rates can change unexpectedly over time. Inflation can erode your purchasing power. Due to the short-term nature of investments in the money market, these risks may be somewhat mitigated but are still present.
U.S. Treasury Bills are considered the benchmark for risk-free investments in the U.S., since they are backed by the U.S. government. The risk-free rate is affected by the Fed’s actions to control inflation or stimulate the economy by adjusting the federal funds rate – the rate at which financial institutions can lend the money they hold in the Federal Reserve to each other overnight. When the Fed raises rates, the value of stocks generally declines and the interest rate on government securities such as T-bills, which are viewed as the safest investments, usually increases. In order to be compensated for assuming additional risk, you would expect a return higher than the risk-free rate to make other types of investments.
Some money market investments are guaranteed. The money you hold in an interest-bearing checking account, savings account, certificate of deposit or IRA retirement account can be considered no-risk to the extent the account is insured by the FDIC, now up to $250,000. Money market deposit accounts offered at an interest rate set by the bank are also insured by the FDIC.
Money market mutual funds are not the same as money market deposit accounts and are not insured by the FDIC. The risk of a money market mutual fund is related to the types of investments the fund makes. These could include Treasury bills and other short-term government securities, short-term CDs and commercial paper, which is short-term debt issued by corporations. The relative risks of different money market mutual funds would depend on the mix of different types of short-term investments, particularly how much of the fund is invested in commercial paper or other securities.
Money market mutual funds attempt to keep their net asset value at a constant $1 per share. But if the investments perform poorly, it is possible to “break the buck.” As indicated by the SEC, due to extraordinary events in the financial markets, on Sept. 19, 2008 the U.S. Department of the Treasury announced an emergency, temporary guarantee program to protect money market mutual fund shareholders .
You could be exposed to risk with money market mutual funds that have a “plus” added to the fund’s name. These plus funds could be “enhanced cash ” products that may not be registered with the SEC. They may offer higher yields by exceeding SEC restrictions governing the credit quality, diversification and maturity of their investments.
Some money market funds have invested in mortgage -related securities called structured investment vehicles, or SIVs, that have declined in value and have even led to the downfall of some of these funds. And money market funds with significant stakes in big companies that have gone under or had to be bailed out are no longer the safe haven they may have been in the past.
Information is the key to balancing risk and reward in the money market, and a higher return can be a red flag for higher risk. By being sure your account is FDIC insured, by comparing competing interest rates offered by banks, by reading the prospectus before investing in a money market mutual fund and by diversifying your money market mutual fund investments you can rest more assured that your money is safe and earning you a reasonable return.
BankingMyWay.com – The Best Places to Park Your Cash, by Philip Van Doorn: http://bankingmyway.com/article/best-places-park-your-cash
Federal Deposit Insurance Corporation – Insured or Not Insured? www.fdic.gov/consumers/consumer/information/fdiciorn.html
MainStreet.com – How A Fed Funds Rate Cut Will Help and Hurt You, by Peter McDougall:
MainStreet.com – What You Need to Know About Bank Deposit Insurance, by Lyneka Little: http://mainstreet.com/article/money/insurance/what-you-need-know-about-bank-deposit-insurance
MainStreet.com – What You Need to Know About SIVs: http://mainstreet.com/article/money/credit/what-you-need-know-about-sivs?page=1
TheStreet.com – Making Sure Investments Beat Inflation, by Lauren Tara LaCapra: www.thestreet.com/s/making-sure-investments-beat-inflation/markets/marketfeatures/10416253.html
TheStreet.com – Beginner’s Guide to Risk Tolerance: www.thestreet.com/story/10398055/1/beginners-guide-to-risk-tolerance.html
U.S. Securities and Exchange Commission – Money Market Funds: www.sec.gov/answers/mfmmkt.htm