In a recent interview, legendary hedge fund manager Ray Dalio stated that “Cash is trash.”
It’s true that cash is not known for providing investors with high levels of excess returns in a portfolio. However, it’s still considered one of the three primary asset classes (along with equities and fixed income).
Furthermore, when used correctly, cash can play an important role in a savvy investor’s portfolio strategy.
That being said, there are a few things one should be aware of if they intend on holding onto a large amount of cash. Primary among the risks are inflation risk and missing out on precious market growth. So, if an investor is putting their capital directly to work in the markets, what can they do to earn yield above and beyond what banks offer?
That’s where money market securities – also know as money market investments – come into play.
In this article, you’ll learn what money market securities are, along with their pros and cons. You’ll also learn how you can access them and implement them in your own investment portfolio.
Before we continue, Financial Professional wants to remind you that this article serves educational purposes only. Any securities or firms named are for illustrative purposes only and do not constitute financial advice. Always do your due diligence and consider your situation – and the help of a licensed financial professional – when making investment decisions.
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What are Money Market Securities?
Money market securities are investments that provide investors with higher levels of yield (interest) than a checking or savings account while still offering the same level of principal protection as outright cash.
For all intents and purposes, you can view money market securities as cash in a portfolio. They are still subject to the same risks as traditional cash. Primary among these risks are purchasing power (inflation) and the opportunity cost (not investing).
Most money market investments are actually short-term fixed income (bond) investments. Typically, investments that fall under the money market umbrella have a term of one year or less.
Like other types of debt securities, the term of the loan influences the yield on money market investments. In other words, the longer the term, the higher the yield. Furthermore, money market yields are 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. This makes them attractive candidates for places to park cash temporarily.
Why Use This Type of Investment?
As discussed earlier, the point of cash in a portfolio is not to provide investors with high returns. Instead, you should view cash as a tool to acquire investment assets or provide you with liquidity.
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.
Moreover, if you decide to escrow such payments as your property taxes, you could hold the funds in a money market mutual fund or money market account until the tax bill is due. That way, your funds earn at least some interest, rather than sitting stagnant.
Furthermore, if you have a substantially large investable asset base, you may be able to generate a fair amount of portfolio income with the yield kicked off by money market investments. This is especially true when used to supplement dividends and bond interest payments.
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 extra yield on their cash.
Money market accounts are alternative types of accounts that some banks offer. Their purpose is to incentivize investors to keep their liquid assets within 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. Typically, 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 mutual 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. This is useful for plan participants who 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 on the market. 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 usually fluctuates 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:
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 in addition to losing purchasing power over time. If your goals require you to have a larger portfolio in the future than what you have now, you will need to invest, not sit 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.
A Final Word
While 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 in the comments below!