As the financial crisis became increasingly serious from 2006 to 2008, U.S. investors transferred over $1.5 trillion into money market mutual funds as a financial safe haven.
Over the next two years, cash flowed out of these funds almost as quickly as it poured in, as investors rushed to purchase growth-oriented securities in the recovering stock market.
Although such a pattern reflects a natural reaction to market volatility, it may not be the wisest course of action.
Weigh Stability Against Growth
Money market funds are mutual funds that invest in cash-alternative assets, most frequently meaning short-term debt. They strive to maintain a value of $1 per share, which is why they may be appealing when investors shift into a loss limitation mode. That said, money market funds typically offer low yields that have dropped to almost zero in the prevailing environment of low interest rates.
Because of this low growth potential, shifting a majority of assets into money market funds as a risk-averse strategy during times of market volatility may result in a different kind of risk: chiefly that your investments may struggle to keep pace with inflation and could miss out on an opportunity to grow.
Consider this past recession...
On March 5, 2007, the S&P 500 — a broad measure of the U.S. stock market — stood at 1,374.12. Two years later on March 5, 2009, the index hit its lowest point during the recession, closing at 682.55. On March 5, 2012, three years after the low point, the index was at 1,364.33 and trending upward.
Confident investors who stayed the course throughout this five-year period could have weathered the economic crisis and been poised to take advantage of any potential future market gains. By contrast, investors who sold assets when the market was near its low point may have experienced losses; experiencing the double hit of a low price of sale and missing out on potential growth when the market rebounded, as their money lingered in the low growth money market funds.
A Tool During Times of Financial Turbulence
Money market funds could help you create a portfolio that is appropriately allocated based on your risk tolerance and needs. In addition, you might use money market funds on a temporary basis to hold proceeds from the sale of assets until you are ready to reinvest. Money markets also provide a place to hold emergency savings.
Although money market funds can offer a helpful alternative in your financial strategy, it’s important to understand their limitations.
Note: Money market funds are neither insured nor guaranteed by the Federal Deposit Insurance Corporation or any other government agency.
Although money market funds seek to preserve the value of your investment at $1 per share, it is nonetheless possible to lose money by investing in these funds and advice from your finance professional is always recommended.