Thursday, January 17, 2013

What are money market funds?

A money-market fund is a very low-risk type of mutual fund, meant to be as close to cash as possible while still earning a modest return. It is different from a money-market account, which is a type of deposit account in which the entire principal is invested in money-market funds by the bank. One key difference is that money-market accounts are FDIC-insured, while money-market funds, like all mutual funds, are not.

Short-term savings

Money-market funds are meant to be very "liquid," meaning they are easier to cash out at any time without expecting a loss, and thus are used for many short-term savings needs:
  • an emergency fund
  • a savings account for a down payment for a house
  • a college fund for teenagers
  • a savings fund for travel or other near-term needs
  • a "parking place" for money while you decide how to invest it
The investments that make up a money-market fund are "cash and cash equivalents." These are limited to highly rated debt issues (think AAA and AA) that mature in 13 months or less. Typically, money-market funds are mostly invested in U.S. treasury bonds, CDs from highly rated U.S. and foreign banks, and commercial paper (similar to bonds, with much shorter maturities, and usually issued by banks or very highly rated companies).

Retirement savings

A money-market fund is an investment choice you can make in most retirement accounts, including IRAs. Many retirement savings accounts, especially those managed on behalf of employees -- 401(k) accounts and the like -- make the default investment into money market funds. These default investments are made for funds that allow participants to make decisions about where to invest, also known as "elections." If you don't make an election, the fund manager is required to put your money into something relatively safe with at least a small expected return.

Growth expectations

The average annual growth for money-market funds tends to be at the low end of the spectrum, a reflection of the low risk associated with these funds. The Fidelity Cash Reserves Fund, one of the largest such funds available, shows historic annual returns between a low of 0.02 percent (2010) and a high of 4.97 percent (2007) over the past decade -- comparable to the interest rates in an ordinary bank savings account.

Loss of principal is rare

Money-market funds are meant to maintain "nominal value" -- in other words, the principal value is never expected to fall. If you have a $1,000 investment in a money-market fund, your account balance should never fall below $1,000. If it does, it's called "breaking the buck" and it's very rare. It has happened recently, though: in 2008, during the financial crisis, the Reserve Primary Fund became "illiquid" (it was unable to issue cash to investors who asked to withdraw their money) because it was invested in securities issued by the ill-fated Lehman Brothers. Even these investors eventually recovered 98 cents on the dollar.
Money-market funds are mutual funds, but most mutual funds hold at least a portion of their portfolio in money-market funds, given their relative safety.

Should I risk money in the stock market?

Before you begin to answer the question, "Should I risk money in the stock market?" you should first assess your investment goals, needs and risk tolerance using this series of questions:
  • What are my investing goals?
  • When will I need this money? (Or: What is my investment timeline?)
  • What is my risk tolerance?
The answer to the larger question about whether you should risk money could be "yes" for one person and "no" for another person in the exact same financial situation -- same age, same goals, same income, same investment timeline. Some of us are just better able emotionally to handle risk than others and are more comfortable with the inevitable ups and downs of the market. Others of us would rather play it safe, even if that means delaying retirement or getting by with less (now or later).

It's OK to say 'no'

If the word "risk" is the one that stands out the most when you ask "Should I risk money on stocks?" it's likely that you've already come up with an answer. You're thinking of it as a risk, and it sounds scary. You need someone to talk you into taking the plunge. Here's the thing: you don't have to. It's OK to say "no."
There are plenty of investments that can help you grow your retirement savings (or whatever money it is you're thinking about investing) without putting your principal at risk (at least, not nearly as much as stocks). With today's CD rates, that money won't grow quickly, but it's a lot better than not saving at all. If you're going to spend most of your time worrying about losing your money on stocks, maybe investing somewhere safer will save you costly stress. (Yes, stress costs you, both in health effects and in well-being, which has a long-term effect on perceived wealth.)

Historically, stocks outperform everything else

Yes, it's true, the stock market is volatile. And it is possible to lose 20 percent, 30 percent or even your entire investment in one given stock (it's happened to me) if things go horribly wrong. But you can hedge, or greatly lessen, that risk by investing in stock index funds or other widely diversified mutual funds. And, over time, even in the worst of times, stocks have held their value and grown. You can pick a time frame of a few years that might show a great decline in a diversified basket of stocks, but if you pick a time frame over 10 years, it's highly likely you'll see modest growth -- and in some cases the growth is eye-popping.
If you're willing to wait long enough -- 30 years is, for the record, "long enough" -- you can be confident of receiving a stock market return that's significantly better than bonds or CDs. (Of course, historical returns are no guarantee of future results; they do, however, give many investors far more confidence about future results.)

Say 'yes' if you have the time to ride out the ups and downs

If you have 20 or 30 (or more) years before retirement, and your risk tolerance is at least fair-to-middling, you may decide it's worth the risk to invest in the stock market. Just about everyone will tell you to make sure your portfolio is diversified, so when you're risking money, you're not risking everything in one basket. But the thing about gaining wealth is that it does take swallowing some risk. You just need to figure out how much you can tolerate.

Should I Use a Broker?

Brokers, like, in Boiler Room?

Before we answer the question, "should I use a broker to buy and sell stocks?" we should distinguish what, exactly, we expect a broker to do:
  • All brokers are legally permitted to buy and sell stocks, bonds and other securities, like derivatives and commodities, on a stock exchange on behalf of a client.
Many brokers perform additional services (and if you've ever watched a movie featuring stock brokers, this is likely what they were doing):
  • Many brokers advise clients on which stocks and bonds to buy and sell, how much, and when
  • Some brokers provide additional financial services or recommendations, like asset allocation, estate planning, the tax impacts of certain investments, and even small business or real estate investment ideas. Such an individual might have an additional certification, like the Certified Financial Planner designation.

From the comfort of your own home

If all you want to do is to find someone to carry out an order as you execute it -- to make a specific stock purchase for you when you decide the time is right -- then you do need a broker (someone who, by virtue of having passed the Series 7 examination, is legally permitted to buy and sell stocks and bonds). But you don't actually need to have a personal broker; a person to whom you talk. Online brokerage firms which let you type in stock symbols and quantities of shares and click, "buy," will do just fine. You'll typically pay far less for the service, and you won't have someone's advice mucking up your investing chi.

Would you hold my hand?

If you, conversely, have no idea either what stocks you might want to buy or how to go about creating a "portfolio," or even only the vaguest idea what a portfolio is, you may be the perfect candidate for the sort of broker who calls you on the phone and says, "I want to see you in some GE stock pronto!" I speak from a very jaded perspective: my husband was once employed (until he couldn't take the culture any longer) by a prototypical "boiler room" style brokerage. And so I can say this: you do not need a broker who has come to you through cold calls or by having been referred by an acquaintance. These individuals are, more often than not, being encouraged to sell certain stocks and are less likely to be making decisions based on your needs; especially if they call you up out of the blue insisting that you need to "get in on the ground floor" of some specific investment.
You need a broker working for a bland, low-pressure firm, a so-called "storefront" brokerage where you can walk in and sit down at someone's desk and see that there's no one yelling or putting your name on a white board. You've surely heard their names on TV commercials and seen them downtown; ask around your office or group of friends and find out if anyone else you know has a recommendation (my advice: steer clear of relatives of people you know; in my experience one has a far lower bar for relatives than for less emotionally connected service providers).

DIY investing

If I taught personal finance in high school, I would tell my students to experiment with do it yourself investing and hope that began a lifelong interest in the market. Most studies show that highly-paid investment advisers and mutual fund managers aren't really much better at stock picking than random chance (if at all). In my opinion, it follows that you are the best one at picking stocks for you. If you read up on how to create a diverse portfolio, and how to (roughly) allocate assets, you will likely do a great job of picking out your own stocks. Maybe you are a coffee nut and you've found the next Starbucks. Maybe you've noticed a chain's stores are run-down in your city and you decide against investing in that company's stock. There are plenty of resources (like right here!) and it's possible to find investing clubs just about everywhere, where you can DIY together.

You need a brokerage

It's definitely the case (unless you yourself are a licensed stock broker) that, in order to invest in stocks and bonds, you need a brokerage. Whether it's an impersonal online brokerage with which you only communicate by clicks and all-caps letters and numbers, or an office where you can walk in and shake someone's hand, is a matter of personal preference. My own preference is to learn about stocks on my own and make decisions based on my values and financial situation. I am, after all, the one who knows me best.

Is 'Buy and Hold' a good investment strategy?

The buy-and-hold investing strategy explained

If you are trying to decide which investing strategy to use after having learned a bunch of new financial lingo, you might be thrilled to come across the buy-and-hold strategy. What you see is what you get! The buy-and-hold investing strategy is simple:
You purchase stocks and hold them for a long time, decades even, until you retire or even longer.
Phew. That was easy! Now, is it a good idea?

Warren Buffett does it. So how could it be wrong?

I believe in Warren Buffett. I'm the sort of fan who's read all the books and stood in line for hours to listen to him live (that's a good story for another time). It's really hard to argue with the third-richest man in the world, according to the Forbes 2012 World's Billionaires list. And Warren Buffett is a fanboy, too, of so-called "value investing"; the concept espoused by early investing great Benjamin Graham.
Value investing is almost just like buy-and-hold, but it's more of a focus on the stocks whose market prices (i.e. the value of the stock times the number of total shares) are less than their actual value, and hold them for years and years, or until the market price finally comes up to their real value.
This takes a lot of analysis, of course, which is supposedly what makes Warren Buffett so rich. But I'm tempted to believe it's not so much the careful monitoring of the value of the companies but the long-term, patient, unwavering holding that has made him rich. Sure, you've got to pick good ones to begin with. But when you're buying stocks with an eye toward holding them for decades, it's a lot easier to discard trendy companies or speculative, high-risk businesses.

'Buy and Hold' makes sense for everyone. Except…

I really believe in the buy-and-hold strategy, although there are certainly cases when one might want to get rid of a stock. Say, if it has gone bankrupt or the CFO has been indicted for accounting irregularities going back years (these are two examples of cases when I sold a stock; though, to be honest, in the second case I was too late to sell; the stock plummeted to $0 immediately). Or, if a company has done something you personally think is really stupid. Plenty of people sold tobacco stocks when they went before Congress insisting that their product was not addictive. But it's hard to find exceptions to the rule. Here are a few cases in which 'buy and hold' isn't a good strategy.
  • If you're a professional investor with great access to information and lots of technical knowledge and experience. This would seem to be a great time to throw out the buy-and-hold strategy, except for data that professional money managers can't even beat the stock market index funds over time.
  • If you don't have much money and want to own a diverse group of stocks. Well, in this case a stock market index fund might be a good choice for you. But it would still make lots of sense to buy the index fund and hold for a long time; knowing when to sell the fund (when the market was falling, theoretically) and rebuy (before it rebounded but JUST before) would be beating the market; and we just said that was near impossible!
  • If your risk tolerance is extremely high and you were born to be a day trader. OK, sure, go crazy if you think you can't live any other way. I did have one friend (one!) in business school who made his entire business school tuition day trading during our second semester. He went on to be a Wall Street trader (of course). But even he told me he didn't think this was something he could replicate. It was just him taking advantage of that notoriously irrational exuberance resulting in a one-time success.
I can't really think of any legitimate reasons not to use the buy-and-hold investment strategy. Given that, and the famously successful examples of that strategy, I think, for a beginning investor, it's a great way to dip your toe into the stock market.