In a recent interview, legendary hedge fund manager Ray Dalio stated that “cash is trash”.
While cash is not known for providing an investor with high levels of excess returns in a portfolio, it is still considered one of the three primary asset classes along with equities and fixed income.
Used correctly, cash can actually play an important role in a savvy investor’s portfolio strategy. That said, there are several things one should be aware of if they intend on holding onto too much cash, namely inflation risk and missing out on precious market growth.
So if an investor is putting much of their capital to work in the markets, what can they do to earn some yield above and beyond what is offered at a bank? That’s where money market securities come into play.
In this article, you’ll learn what money market investments are, along with their pros and cons. You’ll also learn how you can access them and implement them in your own investment portfolio.
What Are Money Market Investments?
Money market securities are investments that are designed to provide investors with higher levels of yield (interest) than a checking or savings account, but still offer the same level of principal protection as outright cash.
For all intents and purposes, money market securities can still be seen as cash in a portfolio. They are still subject to the same risks as traditional cash:
- purchasing power risk and
- the opportunity cost of not investing the money
Most money market investments are actually short-term fixed income (bond) investments. Most investments that fall under the “money market umbrella” have a term of one year or less.
Like other types of debt securities, the yield on money market investments is typically influenced by the term of the loan. In other words, the longer the term, the higher the yield.
Money market yields are also highly sensitive to short-term interest rates.
Classic examples of money market securities include:
- Treasury Bills
- Certificates of Deposit (CDs)
- Commercial Papers
- Bankers Acceptances
- Repurchase Agreements
These types of investments are highly liquid and offer principal protection, making them attractive candidates for places to park cash temporarily.
Why Use Money Market?
As discussed earlier, the point of cash in a portfolio is not to provide an investor with high levels of returns. Cash should be seen as a tool to acquire investment assets or provide an investor with liquidity when an event arises that requires it.
If you are currently in a position where you are holding a great deal of cash in order to acquire assets at a discount during the next recession, you may want to consider earning some yield on those dollars while they are sitting on the sidelines.
If you decide to escrow your property taxes, you could hold the escrowed funds in a money market mutual fund or money market account until the tax bill is due. That way, your funds are at least earning some interest while you keep them parked.
If you have a substantially large investable asset base, you may be able to generate a fair amount of portfolio income by supplementing dividends and bond interest with the yield that is kicked off by money market investments.
Just like you can “ladder” bonds, you can “ladder” CDs with varying maturities. As a CD matures, you can “roll” it back into the CD ladder, purchasing another CD that has a longer maturity than the other CDs on the “rungs” of the ladder. This is a common way of managing interest rate risk, which money market investments are still subject to.
As you can see, there are plenty of ways that an investor can leverage money market securities. As with any other investment, it’s important to have a real strategy behind why you use a certain type of money market investment over another.
Money Market Accounts
Aside from owning individual T-bills or Certificates of Deposit, investors can also leverage money market accounts to get a little bit of extra yield on their cash.
Money market accounts are alternative types of accounts offered by banks in an attempt to incentivize investors to keep their liquid assets with the respective financial institution. Certain banks offer more attractive yields on these types of accounts if you bring over additional assets from other banks or institutions.
Money market accounts vary in terms of requirements, eligibility, etc.
Before opening a money market account with a bank, it’s wise to research things like:
- Minimum Required Deposit
- Minimum account balance
- Number of withdrawals allowed
Note: While funds in a money market account are protected by the FDIC and/or NCUA, it’s still wise to make sure the financial institution you plan on doing business with is covered.
Money Market Funds
Another practical way of accessing money market investments is via money market funds.
Money market mutual funds are designed to maintain a level Net Asset Value (NAV) of $1, while providing investors with some yield. Most employer-sponsored plans, like 401Ks, have a money market mutual fund option for plan participants that want to keep a portion of their retirement plan balance in cash.
There are also a handful of money market Exchange Traded Funds (ETFs) available to trade. Proponents of ETFs like the liquidity and convenience that they offer. Many of these funds are very inexpensive to own as well. The value of these funds can be expected to fluctuate with the short-term interest rate environment.
Money market ETFs can be easily traded in your brokerage account and/or Individual Retirement Account (IRA) or Roth IRA.
As with any type of fund that you intend on adding to your portfolio, make sure that you understand the underlying holdings of the fund prior to purchasing it.
It’s also very important to note that money market mutual funds and ETFs do NOT carry FDIC or NCUA insurance.
How Much Should I Keep Invested In the Money Market?
The short answer is: it depends. The main variables that the answer to this question depends on are:
- Your Investment Time Horizon
- Your Financial Goals
- Your Risk Tolerance
Generally speaking, if you still have a lot of time between you and your future financial goal, you should not keep the majority of your investable assets in cash. You will be missing out on potential market growth, and also losing purchasing power over time.
If your goals require you to have a larger portfolio in the future than what you have now, you need to be invested, not sitting in cash.
Risk tolerance becomes more of a consideration as you approach your financial goal and you have a large enough portfolio of assets that can support your goal(s). If you’re at a point where your portfolio is large enough, you may be able to “afford” to not be as aggressive. In this case, you can have a larger allocation towards bonds and cash versus equities.
While the extra yield compared to a traditional savings account is attractive, know that it will certainly not be enough to help you meet your future financial goal(s) if you are in need of substantial portfolio growth.
ConclusionWhile you can certainly overdo it, having some “dry powder” on the sidelines makes sense as a part of a broader portfolio strategy. Maybe you are keeping your emergency savings fund in a money market ETF for a rainy day. Perhaps you are parking assets in a money market mutual fund, waiting for the next correction. Whatever the case, there are plenty of good uses for cash.
Money market investments can serve as a handy tool for individual investors looking to squeeze out a little bit of extra yield from their cash positions while protecting their principal from the volatility of the capital markets.Have questions on money market investments? Let us know!