What Is A Money Market Fund And How Do I Use One?

Learning about money market funds and how to use them in your investing programs can help you make better investment decisions, both protecting your assets and allowing you to earn more in the long run.

A money market mutual fund (bit.ly/Z1uvGU) is a mutual fund that invests in assets that are so stable that the fund maintains a constant price of $1 per share. Money market funds are not FDIC insured (though some banks have offered savings accounts or even checking accounts with the name “money market” but they are FDIC insured and are not mutual funds).

The money market refers to the instruments the fund invests in. The investments include mostly the sorts of instruments that consumers and small investors don’t normally buy directly. These include short term treasury obligations (T-bills) and commercial paper (short term corporate obligations). Everything in the portfolio of a money market fund would be expected to mature within a few months. The cash is then reinvested.

Money market funds earn low returns but are generally considered safe despite their lack of a formal guaranty. The industry is carefully regulated and investor losses in this space have been tiny. You can reasonably expect to get your money back with interest.

Most investors look at three primary types of assets for their long term investments. Stocks, bonds and cash. All of these can be accessed using mutual funds. If your family owns mutual funds for its stock and bond investments, it may make sense to put your cash investments in mutual funds as well. You can keep all of your mutual fund holdings in a brokerage account.

Because cash investments of all sorts, including money market funds, don’t generate a lot of interest or dividends, and they don’t ever go up in value, they don’t make great investments. As you approach retirement especially, people often like to move a portion of their investments into cash. This lowers the anticipated return on the portfolio but, more importantly, it reduces the risk of loss.

Keeping your cash in a money market fund between investments is generally a wise idea. Let’s say you have $20,000 invested in your IRA at a large discount broker. You might make investments in several different mutual funds and end up with some money left over. Or you might sell one and decide to take some time to figure out which new fund to invest in. These are opportunities to invest in a money market mutual fund so that your cash is safe, but not completely idle.

Some brokerages will put your cash into a money market fund automatically, even if you don’t ask for that. Others will give you the option to automatically sweep your cash into a money market fund. Some only make that option available for people with large accounts. Even if you can’t sweep all of your balances into a money market account, you can move money into a money market fund just like you move money into a mutual fund that invests in stocks or bonds.

Because of the low returns on money market mutual funds, you want to be sure to avoid any transaction fees at all (unless you have lots and lots of money invested). Today, a $1,000 investment in a money market fund might only earn $10 in a year. If you have to pay $10 to get in and $10 to get out of a money market fund, you’ll lose ten dollars. You’d be better off to have your cash sit idle for a year earning nothing.

Money market mutual funds are a key part of your investment strategy. Though you are unlikely to keep much money in money market funds, you’ll almost always want some of your money there.

What Is Asset Allocation And How Do I Do It?

Asset allocation is the practice of strategically balancing a portfolio among several asset classes. There are three classes of assets that typical families should include in their investments: stocks or equities, bonds and cash. When you finish reading this short article, you’ll know all you need to know to properly balance your portfolio.

First, some definitions:

Equities: This is a Wall Street word for stocks, referring to their name in the financial statements.

Bonds: Bonds are loans issued by corporations and governments with set payment schedules, most commonly periodic interest payments with all principal paid at the end of the loan term, or maturity, all at once.

Cash: In investment speak, cash doesn’t refer to the stuff under the mattress, but the stuff in the bank and similar places. Very short term government and corporate debt securities (short, as in 30 to 90 days) are typically included in investors’ definitions of cash.

You can invest in each of these asset classes using mutual funds or ETFs (Exchange Traded Funds); together, let’s call them “funds.”

Equities have the highest risk and are generally expected to have the highest return on investment. Bonds have less risk, but still have risk loss of principle and the income on bond funds varies significantly from year to year. Cash features ultra-low risk and correspondingly low returns.

The goal of asset allocation is to match your risk tolerance, return on investment goals, and investment objectives to your portfolio. For short-term objectives, investing only in cash or in cash and bonds would generally make sense. For long-term objectives, like retirement, investing in a combination of all three would be considered wise.

People in their twenties investing for retirement have the flexibility, if they are risk tolerant enough, to be invested 100% in equities. As people age, retirement gets closer and the pain of a major setback in investment returns looms larger so they generally shift the allocation to include more bonds and even a bit of cash. It is prudent for most people to keep a portion of their investments in equities even after retirement because retirement itself can last twenty years or more.

There are no absolute rules in asset allocation, but many investors seem to see about two-thirds of a portfolio as a limit for any single asset class.

Some investors use asset allocation shifts as a way to “time the market,” that is they shift their asset allocation not based on changes in their own circumstances (like nearing retirement) but they shift as their opinion of the markets changes. This practice will increase the risk in your portfolio because you are adding a new variable to the equation. You’ve now added your economic and financial forecasting skills to what is already a complex equation. There is plenty of evidence that the Chairman of the Federal Reserve has difficulty forecasting economic results and he can influence them more than anyone. Chances are, you’ll do even worse and risk making your allocation shifts at the wrong times, causing losses you wouldn’t otherwise experience.

As you go through life, you can and should slowly adjust your asset allocation. This can often be accomplished simply by investing new dollars in the asset class you’d like to grow. Over time, this should have the effect of reducing the percentage of your portfolio invested in other assets. In this way, you never need to sell assets just to shift your allocation.

Thoughtful adjustments to your asset allocation will better prepare you for retirement.

How Does “Dollar Cost Averaging” Work To Improve My Investment Returns?

“Dollar cost averaging” sounds like a mysterious accounting term that requires a degree in business to understand. It isn’t. Not only will this short article explain the concept completely, it will also help you understand that you may already be doing it and that it is likely helping your long-term savings plan.

Dollar Cost Averaging: This phrase refers to the idea of investing the same amount of money each month (or week, or every two weeks) in a mutual fund (stock, bond, ETF, REIT, etc.).

By investing the same amount each month in something with a fluctuating price, like stocks, bonds, REITS, ETFs, etc., you accidentally get a small benefit over the long haul. You are likely to buy more shares than if you bought in one big lump or, even worse, tried to “time the market” by buying when prices are low.

You see, what happens when you buy the same dollar amount each period is that in the periods when the price is high, you acquire fewer shares or units. In the periods when the price is low, you acquire more.

Consider this example:

If you bought $100 worth of shares each month on the first day of the month in a mutual fund initially trading at $20, you’d buy 5 shares on the first day. If the price moves up to $25 for the next month, you’d acquire only 4 shares. If the price drops to $16.67, the next month, you’d acquire 6 shares. Maintaining this discipline over time will generally increase your returns over buying in bigger lumps—if you can avoid transaction costs.

The worst thing to do is to try to beat the system by timing your purchases. Consider the scenario above. Presume that you had the courage to monitor the price for three months before making a purchase of $300 all at $16.67. That sounds brilliant, right? Not so brilliant if the price drops to $10 the next month. Often people make the bigger mistake of letting price momentum carry them away in a rush of panic, investing everything at $25—expecting the price to continue climbing.

The great thing about dollar cost averaging is that you are already doing it if you are contributing to a 401k. Every paycheck, a little bit of money is deducted for a contribution to the 401k. It is invested on a strict schedule. No one tries to time the market and you are getting the full benefit of dollar cost averaging.

If you aren’t already participating in your 401k, start today! If your employer doesn’t offer a 401k, you can easily get the same benefit by scheduling contributions to a mutual fund each month. As your assets grow, you’ll likely hold your mutual fund investments in a brokerage account. Most discount brokers allow you to invest even small amounts in certain mutual funds with no transaction fees. Note that all of the benefits of dollar cost averaging are overwhelmed by brokerage commissions or mutual fund loads. Avoid them.

See how easy that was. Dollar cost averaging is something you’re probably already getting the benefit of and now can fully understand.

Investment Tips For Nervous Nellies

If any investment without FDIC deposit insurance sounds too risky to you, you’ll never have to worry about losing money in the markets. You’ll sleep well at night, safe and warm in your own bed, until you run out of money. Taking moderately more risk can help you avoid that last part!

Consider the following tips to help you increase the risk in your investments to increase the returns:

1.   The Difference is Huge: If you invest only in FDIC insured deposits, your current returns would be around 1% in the U.S. Investing in a broad portfolio of stocks and bonds using mutual funds would likely yield around 7%. If you invest $10,000 at 1% for 20 years, you’ll have $12,20If you invest your $10,000 at 7% for 20 years, you’ll have $38,69If you can’t take the risk of the stock market, you can likely earn a 5% return in bond funds and end up with $26,533.

2.   Think Long Term: Even if you are about to retire or have even just retired, you’ll probably want your money to last for decades from now. That is generally considered to be a long enough investment horizon for you to take some risk.

3.   Think Like An Investor: If you simply decide to think like an investor, recognizing that investments go up and down in value, you may be able to sleep at night even if some of your money is no longer FDIC insured.

4.   Diversify: If you make lots of different investments in a variety of mutual funds you will see that some may go up when others go down, allowing your total portfolio to remain somewhat more constant. You can keep some of your investments in FDIC insured deposits so that you don’t lay awake at night worrying, too. Investing in five to seven different mutual funds with different objectives from several different fund families provides effective diversification.

5.   Allocate Your Assets Strategically: As you’re choosing your mutual fund investments, remember that funds that invest in stocks will fluctuate the most while funds that invest in bonds will earn a bit less over time. The money you keep in cash is the safest but it will earn the least. You can choose how to allocate those investments, but most advisors would recommend keeping at least one third in stocks until it is clear that your money will not last for the next ten years, at which point shifting to all bonds and cash would be safer.

6.   Find A Trusted Friend. You may want to find someone you trust to help you and your spouse find the right balance of risk and return. 

7.   Save More: If you still can’t stand the thought of putting money into investments that have any chance of losing money, you need to be saving more. Much more. Talk to your spouse about building a budget that will allow you to save as much as possible for the future.

It is ironic, isn’t it. Sometimes taking too little risk is the biggest risk of all. Don’t let that overwhelm you. There are prudent ways to take moderate amounts of risk so that you can afford to retire someday and still sleep at night.

Investment Tips For Investment Daredevils

If you like to take risks with your investments, here are some tips to help you have fun while you invest without exposing yourself to catastrophic risk.

1.   Be realistic: For just a moment, picture yourself as an investor doing battle with Wall Street. If you are actively taking investment risks, that’s what you’re doing. You may be able to beat the market for a year or two, but you are highly unlikely to beat the market over the long haul. It’s fun to try and over time you’ll likely improve your abilities, so don’t give up. Just don’t put all of your money at risk.

2.   Diversify: If you like to take investment risks, you may not be getting paid for all the risk you’re taking. The market is broad and assets are priced as part of the overall market. If you are putting all of your eggs in one basket, you’re taking risks without added upside potential. Choose to make many more, smaller investments in different areas and that will help to eliminate the risk you’re not being paid to take.

3.   Quarantine the risk: Risk taking is genuinely fun for some investors; investing becomes a hobby. It can certainly pay better than lots of other hobbies, so it’s not such a bad idea. You may want to separate your real, long term, cautiously invested portfolio from the money you like to play around with. If you keep 80 to 90% of your money cautiously invested—and keep contributing to your savings in the same proportion, you’ll keep your nest egg growing regardless of what happens with the money you’re putting at risk.

4.   Have caution with options: Investing in options over the long haul has a negative expected return. Options are a zero sum game—one player’s winnings are another’s losses. What’s worse is that the game is rigged: someone in the middle takes a commission so you aren’t even expected to get your money back. Writing naked calls is an easy way to make money until it bankrupts you. (If you don’t know what that is, you’re almost certainly not doing it.) Options offer the same thrill as gambling because they have the same expected return. The house always wins.

5.   On Shorting: Shorting stocks (or other assets), that is the dangerous practice of borrowing someone else’s shares to sell them in hopes that the price will decline and you’ll be able to buy the stock cheaper to cover the loan. Keep in mind that when you buy a stock the old fashioned way, the upside is infinite. There is no absolute limit to how high the stock price can go. You can only lose 100% of your investment in a stock you own. If you short a stock, you flip that relationship upside down. You can lose an infinite amount of money—more than you potentially have, but your upside is limited to the price at which you shorted the stock.

6.   Private investments: If you have some money, you may be tempted to make investments in startups and real estate. Many of the professionals in these areas have lost money—lots of money—by making bad investments. If you’re just starting out, find a guide who won’t be making money off of you to help you make wise investments.

If you’re an investing daredevil, these tips will help you avoid a catastrophe even while you continue to invest a portion of your portfolio for fun. Remember, your family is counting on the investment s you make to provide for retirement and college. You have a responsibility to make sure that money is there.

How Much Investment Risk Should I Take?

Knowing how much risk to take when investing is a difficult question. In 2007 and 2008, it became clear that the largest banks in the world had not been able to measure the risks involved with their biggest bets (I’d call them investments, but in hindsight it is clear they were gambling). If banks with hundreds of billions of dollars at stake, can’t measure risk accurately, neither can you and I.

The best indicator of risk is the anticipated or recent returns. The higher the anticipated returns, the riskier the investment likely is. In a market where the U.S. Federal Government can borrow money for 30 years for around 3%, you can tell pretty quickly that a bond that pays 13% will be much riskier. If a stock doubled in price over the last year, you can hope that it doubles again this year, but understand that it is a risky investment.

If anyone ever tells you that they have a risk free investment that will pay you more than U.S. Treasuries pay, understand that the investment is not risk free. No one is exempt. (I know I’m certainly not.) It is difficult to measure and understand all of the risks of an investment. In 1999, a group of Nobel Laureates (bit.ly/sKnsX) who were operating a large investment fund nearly crashed the global financial system because they made huge investments that didn’t work the way they expected them to work.

Assuming you don’t have a Nobel prize or a large staff of analysts to help you make your investments, it is easy to conclude that you’ll have a difficult time measuring the risk of your investments, too. Here are some guidelines to help you match your risk to your appetite and circumstances:

1.   You neither can nor should avoid all investment risk.

2.   Take risks that are easier to understand that lots of people are taking rather than unusual risks that are hard to understand. For instance, lots of people invest in mutual funds that invest in growth stocks. Many people can help you understand those risks. Making a bet in future options on commodities would be much harder to understand and there will be fewer people around you to help you understand the risks.

3.   Gauge your circumstances well. If you are young, there are lots of years for you to fix your mistakes. You might reasonably choose to take more risk. On the other hand, if you are saving up for your 15-year-old’s college, you might reasonably conclude that risk is to be avoided.

4.   The more risk you take, the more time you should take to understand the risks. Don’t ever kid yourself into believing that you understand all the risks or that you’ve protected yourself against them.

5.   Be careful with leverage. There are a variety of ways to leverage an investment. This is wall street speak for increasing the potential investment returns of a strategy by using someone else’s money. For instance, buying a duplex has a certain measure of risk and return potential. You can increase the return—and the risk—by borrowing some money from the bank to buy it. The more money you borrow, the higher the theoretical return could be on your money, but the higher the risk you could lose all of it. There are a variety of ways to leverage your bets in the financial markets. They always come with the potential to raise your returns and they always increase your risk.

If you don’t remember anything else after reading this article, remember this one thing: investment risk is almost impossible to measure accurately. Proceed with caution!

How Do I Pick Investments For My Retirement Savings?

Determining how to pick investments for your retirement can be challenging. If we assume that you have at least twenty years until retirement and that your retirement will last twenty to thirty years (that is, you’ll live for twenty to thirty years after retirement) you have 40 to 50 years to recover from the inevitable dips and sags to which most investments are subject. That gives us more flexibility in choosing investments.

For shorter term investing, you should worry most about taking too much risk and ultimately not having the money you need because your investments tanked. With retirement savings—don’t go crazy here—but the risk is almost the opposite. You need to take enough risk to get enough return that you’ll be able to live off of your savings for a long, long time. Frankly, FDIC insured CDs are not going to cut it.

Before going further, please understand that if you cannot sleep at night knowing that your portfolio could be worth less tomorrow than it was today, keep your CDs. Just be sure to save more—much more than your neighbors who can stomach a little risk.

So here we go. Consider the following guidelines for retirement investing:

1.   Diversification is key. It is wisest to use mutual funds as the primary investment vehicle for your retirement savings. Each fund is, within its objective, reasonably diversified, but each fund has a goal. If you were to rely on one fund for all of your retirement savings, you may be concentrating too much risk on one fund manager. You’ll probably be better off with five to ten different funds, remembering that by the time you retire you could easily accumulate $100,000 in each one. Managing more than ten may not add any effective diversification—just complication.

2.   Choose a growth equity fund. A growth equity fund invests in stocks that are expected to grow faster than the market. They don’t always work. These funds tend to appreciate quickly—when the markets do well—and fall quickly when they don’t. Over the long haul you’d expect your growth fund to perform best.

3.   Chose a value fund. A value fund is one that invests in stocks that based on the fund manager’s judgment are undervalued in the market and are expected to rise based less on performance and more on a market correction. These funds don’t swing in value as much as growth funds, but they do go up and down.

4.   Choose a long term corporate bond fund. If you are aggressive, you may even want to consider a “high yield” bond fund that invests in junk bonds. Junk bonds are debts owed by companies expected to have difficulty paying. The yields on these bonds are significantly higher, but losses are not unusual. “Investment grade” bond funds can still lose value due to both credit risk (risk that the issuer defaults) and interest rate risk (the risk that the bond price drops because interest rates rose) but swings are smaller.

5.   Choose an intermediate term government bond fund. The intermediate term government bond fund invests in Federal Treasury and Agency bonds with maturities less than ten years. These funds have virtually no credit risk and relatively modest interest rate risk, so should provide consistent, though modest returns.

6.   Choose a fifth fund to match your age or appetite. You can now choose a fifth fund to skew your portfolio in the direction that makes you most comfortable. If you are risk tolerant and sleep well knowing your funds go up and down in value, you may want to invest in a risky fund to help increase the yield in your portfolio. There are a variety of specialty funds that make concentrated investments in industries, regions and countries. These funds often beat the market one year and trail it dramatically the next. On the other hand, if you are not risk tolerant or are closer to retirement, you may want to make your final fund a short term government bond fund that invests in bonds with maturities of less than four years so there is very little interest rate risk and virtually no credit risk.

Following this basic approach to choosing five mutual funds for your portfolio using theYahoo! Mutual fund screener (bit.ly/Khm6m3), you can build a portfolio tuned to your personal appetite for risk and likely earn returns in excess of CDs—remembering that there are no guarantees.