Money Market Fund Risks

When it comes to investing in mutual funds and money market mutual funds, investors have literally thousands of choices.  Prior to an investor making a choice on an individual money market fund, an evaluation on whether the investment strategy and risks of the fund are a good fit should be concluded first.  The first step to successful investing is figuring out all financial goals and individual risk tolerance.  Making an informed decision that assumes some risk also creates the opportunity for greater potential reward.  This fundamental principle of investing is known as the risk and reward tradeoff.   When any investor is forming an investment plan an examination of personal attitude toward investment risk is essential.  Investors must analyze whether stability is more important than potential higher returns, or can the investor tolerate short-term losses for potential long-term gains.  Once an investor knows what they are saving or investing for, when they’ll need the money, and how much risk is considered tolerable, an investor can more easily narrow their money market fund or mutual fund choices.

Most mutual funds fall into one of three main categories, money market funds, bond funds also called fixed income funds, and stock funds also called equity funds.  Each type has different features and different risks and rewards.  Generally, the higher the potential return, the higher the risk of loss.

All mutual funds involve investment risk, including the possible loss of principal.  Money market mutual funds are no exception, the possibility of a loss of principal is extremely remote but it is possible.  To help preserve the value of your principal investment, money market funds must meet stringent credit quality, maturity, and diversification standards.  However, there is no guarantee that a money market fund investor will receive the $1 per share when they redeem the money market funds shares.  Money market funds do not guarantee that an investor will receive all your money back.  The U.S. government does not insure the entirety of money market funds.

The ability to use money market funds for increasing savings yield or as holding account for changing investments makes these accounts desirable for high and low risk investors.  The short-term nature of money market investments makes money market funds less volatile than any other type of fund.  Money market funds seek to preserve your investment principal while generating dividend income.  Money market funds have relatively low risks, compared to other mutual funds and most other investments.

Money market funds pay dividends that generally reflect short-term interest rates, and historically the returns for money market funds have been lower than for either bond or stock funds.  It may seem logical that the safest investment is one that seeks to preserve your money, like certificates of deposit or bank CDs or money market funds.  While these instruments may play an important role in most overall financial plans, investors should be aware that these investment vehicles may not protect assets against the risk of inflation.  Inflation risk that is, the risk your investment return fails to keep pace with the inflation rate is concern if you choose to invest in money market funds or any other short-term investments.

Inflation can erode the purchasing power of any investment type.  As an example, a $1,000 in a deposit account earns 5.00 percent interest, but if inflation is 2.00 percent per year the real rate of return is only 3.00 percent.  Although this money will earn $50 in interest after one year, inflation cuts the actual worth of this $50.00 down to $30.00.  In addition, the initial $1,000 will also erode by 2 percent to $980.  Therefore, after one year, the account has a balance of $1,050, but due to inflation, its purchasing power is only $1,029.  This is the effect of inflation risk.  To maintain an investment’s purchasing power, its total return must keep pace with the inflation rate.

Inflation rates in excess of the yield earned by the money market fund are considered the number one risk of money market fund investing.  This risk is an inherent risk in all investments that derive their returns from interest or dividends.  That’s why inflation risk or the risk that inflation will outpace and erode investment returns over time can be a potential concern for investors in money market funds.

This entry was posted on Tuesday, January 6th, 2009 at 3:30 pm and is filed under Mutual Funds. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.