Money Market Mutual Funds
Conservative savers often integrate money market mutual funds as part of their own particular cash management strategies. Effective cash management strategies preserve cash flow for meeting day-to-day expenses, while also generating interest income to help build towards long-term savings goals. Money market mutual fund performance closely tracks prevailing short-term interest rates. The money market mutual fund, however, does expose asset portfolios to distinct risks.
The money market mutual fund is not to be mistaken for the money market deposit account. Banks offer money market deposit accounts that carry Federal Deposit Insurance Corporation (FDIC) protection. The FDIC insures $250,000 worth of deposits, per depositor, per banking institution. The FDIC, however, does not guarantee money market mutual funds. Money market mutual funds typically pay higher interest rates than those offered on money market deposit accounts. Although the FDIC does not back money market funds, investment losses related to these products are extremely rare.
Define The Money Market
Money market mutual funds are investment pools that purchase money market securities. Money market securities are short-term debt instruments, or loans, that mature within one year. These investments include treasury bills, commercial paper, and certificates of deposit. Institutions issue money market securities to receive short-term financing for everyday operating costs, such as payroll and office expenses. In exchange, investors that purchase these securities earn relatively small interest payments. Money market securities offer relatively minimal interest payments because of their short durations that translate into security of principal. Alternatively, stocks and long-dated bonds offer higher profit potential, alongside more volatility. Higher potential rewards compensate investors for taking on increased risks.
Federal Funds Rate
Money market interest rates track the federal funds rate as a benchmark, or comparison standard. Banks transacting business and accepting deposits within the United States are required to post reserves at the Federal Reserve. Banks often loan money to each other overnight to meet these requirements. The federal funds rate refers to interest rates charged upon these overnight loans between member banks.
The Federal Reserve Board influences the economy through monetary policy and the federal funds rate. The Federal Reserve Board targets lower federal funds rates amid recession, in hopes of improving the economy. Lower interest rates encourage private individuals and public institutions to take out loans, purchase durable goods, and commit capital for making investments. Alternatively, the Fed raises interest rates to actually slow down a growing economy and protect the marketplace against inflation.
Money market mutual funds are ideal to provide for intermediate savings goals, while also offering financial relief, in case of emergency. For example, a conservative saver may purchase money market fund shares to build savings towards a home down payment, real estate remodeling project, or wedding costs. Beyond these specific goals, money market mutual funds, alongside insurance coverage, can provide income in the event of untimely accidents and job losses.
Inflation and Opportunity Costs
Money market mutual funds do expose savers to inflationary and opportunity cost risks. Inflation describes rising prices for goods and services that erodes the purchasing power of cash reserves. Alternatively, opportunity costs describe the risks of missed profits from competing investments. When the economy strengthens, money market investors are unable to take advantage of bull markets that create real wealth for long-term stock market investors.