When you go shopping at the supermarket, there’s stuff in the store that’s good for you, and then there’s all that junk food that’ll rot your teeth. Investing in the stock market is the same way—there are good investments and bad investments. And one type of investment you might find on the shelves is something called “money market funds.”
Money market funds (sometimes called “money market mutual funds”) have grown more popular over the years, with more than $5 trillion being managed across hundreds of different money market funds out there.1 That’s a lot of money!
Money market funds are seen in the investing world as a type of low-risk, low-reward alternative to investing in stocks—especially for investors just looking for a place to park their money or protect their retirement savings as they get closer to retirement. But should they have a place in your financial plan or are you better off investing your heard-earned cash elsewhere? Let’s dive right in!
What Are Money Market Funds?
A money market fund is basically just a type of mutual fund invested in “short-term debt securities,” which is just a fancy term for money loaned to governments, corporations and banks that is due back to the investors in less than a year, plus interest. In this case, you are the lender and they are the borrower.
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Now before we get too far in the weeds, here’s an important note: Money market funds are not the same as money market accounts. Money market accounts are basically savings accounts offered by a bank or credit union while money market funds are investments. Big difference!
How Do Money Market Funds Work?
Like most other mutual funds, investors pool their money together to invest in something. Except in this case, these investors are not investing in stocks. Instead, they’re investing in debt instruments sold by governments, companies and sometimes banks that allow those entities to borrow money for a short period of time.
Money market funds are in the family of fixed-income investments, which means they’re designed to give investors a steady stream of income on a regular basis in the form of interest payments.
You can buy money market funds from brokerage firms or directly through a bank that sells them. Depending on the type of fund, you might have to put down some type of minimum deposit—anywhere from a few hundred dollars to $5,000—just to get started buying money market funds. But there are some brokerage firms that will let you get started with no minimum deposit at all.
Here are some of the main characteristics of money market funds to keep in mind:
- Money market funds are relatively low-risk investments.
Money market funds are considered “safe” investments because these loans come due within a very short period of time—usually 90 days or less. On the risk scale, they’re less risky than investing in stocks but riskier than parking your money in a savings account.
- Money market funds are highly liquid.
That means that the investments inside a money market fund can be quickly turned into cash that is easily accessible for you to take out of your account.
- Money market funds have slightly better returns than savings accounts.
But my biggest issue with money market funds? Their performance! You can probably expect around 2–3% returns from a money market fund. That might be better than the returns you’ll find with a savings account, but nothing to write home about. Plus, that’s before the fees and expenses that come with a money market fund, which cut into your returns even more. And those kind of returns are definitely not going to be enough to help you save for retirement (more on that in a minute).
What Are Different Types of Money Market Funds?
There are many different types of money market funds out there, but we can basically boil them down to three categories: prime funds, government and treasury funds, and tax-exempt (or municipal) funds. Let’s break each of those down real fast:
- Prime funds are money market funds that are usually invested in corporate debt (sometimes this is referred to as “commercial paper”). Translation? Investors lend money to the companies in the fund and they promise to pay you back quickly—plus a little interest for your trouble.
- Government and treasury funds are usually invested in things like Treasury bonds or other government-backed debt securities that are used to raise money for government spending. Don’t worry, they promise to pay you back too.
- Tax-exempt funds, often called municipal funds, are unique from prime and government/treasury bonds because the money you earn is free from U.S. federal income tax (and, in some cases, from state taxes as well). These funds are usually invested in municipal bonds that raise money for local governments.
Are Money Market Funds Worth Investing In?
The short answer: Absolutely not! Here’s why:
First off, they’re terrible for long-term investing. Remember those wimpy 2–3% returns? That’s nowhere near good enough to help you reach your retirement goals! Here’s why. The cost of things is always rising—usually somewhere between 2–3% every year. That’s called inflation, and you need to be investing at a rate that’s higher than inflation.
Most investors who buy money market funds do so because they want to get a slightly better return on their investment than a high-yield savings account . . . but “safe” doesn’t mean money market funds are a sure thing.
During the 2008 financial crisis, one of the most popular money market funds collapsed and investors ended up losing money.2 And when the coronavirus hit the United States in 2020, the total value of money market funds that buy corporate debt dropped by $120 billion—that means 15% of all the money tied up in money market funds was wiped out.3
So if you’re just looking for a place to park some money or you’re saving for a short-term financial goal—think less than five years—you’re better off putting that money in a money market account than you are in a money market fund. Sure, you’re not getting a great rate of return, but you’re also avoiding the risk of dealing with that kind of market volatility in the short term.
There’s a Better Way to Invest
When it comes to saving for retirement, I recommend investing 15% of your gross income in good growth stock mutual funds inside tax-advantaged retirement accounts like a 401(k) and Roth IRA.
But listen, you should never invest in something you don’t understand. That’s why I always think it’s a good idea to work with an investment professional who can sit down with you and teach you all the ins and outs of investing. That way, you can be confident in the decisions you’re making with your money!
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