11:45 a.m. EDT April 26, 2015 Now, you may point out – correctly – that the interest from a money market fund wouldn't feed a family of gnats, and you'd be correct. The average money fund yields 0.02%, which would generate a fully taxable $2 in interest on a $10,000 balance, the remainder of which would be overwhelmed by inflation.
All true.
But there are three good reasons to park money in a money fund, or a bank money market account.
You need to write a check. This may seem obvious, but if you have money you need to spend within the next year, you should have it in cash. As anyone who was in the stock market in 2008 knows, you can easily lose 20% or more in a 12-month period in stocks. And, while the bond market isn't as volatile as the bond market, a 2% to 5% loss isn't out of the question, even including reinvested interest.
If you have a tuition bill to pay, or a major purchase, you shouldn't let the capital markets determine whether or not you can make the payment. "Sorry, I wanted to pay for your sophomore year, but I lost too much money in the market," is something you'll probably never want to say to your child. Similarly, you probably don't want Mr. Market to determine whether your new car is a new Dodge Ram or 1973 Vega.
You can't sleep at night. In theory, the longer you have before you'll need to spend your money, the more money you should have in stocks. If your goal is more than 10 years away, you should have all, or nearly all, of your money in the stock market. During most 10-year periods, you'll earn more in stocks than you would in bonds or cash. During all 20-year periods, the stock market will beat all alternatives.
And that's fine in theory. Some people can sock away money in the stock market and be blithely unaffected when their account plunged 45% or more. You may not be one of those people. And it's better to hold some cash as a buffer, if that's what keeps you from panicking when the market swoons.
You want to buy when the market is cheap. The best financial position in the world is to be liquid when no one else is. If you'd had plenty of cash on hand in 2009, you could have snapped up stocks (and real estate, for that matter) at thrift-store prices. You just had to have had the cash on hand.
Most people didn't.
Big buying opportunities don't happen often, but when they do, they're fabulously lucrative. Had you bought stocks at the March 9, 2009 low, you'd be up 224%, meaning that $10,000 would now be $32,400.
Having cash on hand doesn't mean that you're going to buy at the exact bottom. Few people do, and most of those who do are fortunate, not prescient. Nevertheless, if you can buy the Standard and Poor's 500 for 40% below its previous high, you've probably got a good thing going. All you need is the cash on hand.
The general definition of cash is "any investment that can be swiftly converted to cash." For most investors, that means a money market fund. Most money funds will allow you to write checks on them, just as you would a bank account. And you can use your brokerage account's money fund to buy stocks, bonds or mutual funds nearly instantly.
Money funds are mutual funds that invest in highly liquid, high-quality securities, such as Treasury bills and jumbo bank CDs. They can't promise you a particular yield: They simply distribute what they get equally among shareholders.
While money funds strive to keep a constant $1 per share price, there's no guarantee that they will. Their track record is pretty good, but not perfect: The Reserve Fund broke the buck in the wake of the Lehman Brothers bankruptcy in 2008.
If you're really worried about having the money when you need it, then an insured bank money market account is probably the better bet. Bank money market accounts have administrated yields, which is to say that you get whatever the bank feels like paying, rather than a true market rate. On the other hand, bank money market accounts have been paying higher yields than money funds for some time now. Just be sure that what you're getting in interest isn't getting eaten up by fees.
Cash has one additional virtue. Short-term interest rates have been near zero since late 2008 – an unprecedented period of extraordinarily low rates. If you were to bet on one investment rising in value in the next two years, money funds would be the safest bet.
