Money Market Funds ...Almost Risk-Free

If you've ever studied finance, then you know that the notion of the risk-free rate is critical to the valuation of many other financial instruments. U.S. Treasury Bills (T-Bills) are most often used as the de-facto risk-free rate, but what about money market funds. Since they were introduced almost four decades ago, not a single retail investor has ever lost a cent. Does that mean that they're risk-free?

No. Fortunately, that shouldn't dissuade anyone from including them as part of their well diversified portfolio. Money market funds tend to offer rates of return slightly better than T-Bills and certainly better than what your bank will offer on your savings or checking accounts. What should be considered as part of the decision, however, is that they are not guaranteed by the government in the same way as your savings and checking accounts are. There is a risk of default and there is a risk that you could lose all or part of your investment.

Money market funds, like other funds, group various types of investment assets together to offer retail investors (that you and me) the opportunity to buy an already-diversified (and presumably less-risky) asset in one go. In the case of money market funds, these include T-Bills, short-term corporate bonds and other, generally high-quality, short-term debt. The fact that they're short-term is important. The fact that they're high-quality is also important. These two facts together mean that it is highly unlikely that a debt instrument that is deemed to be high-quality is to default within one-year or less (the generally accepted short-term duration). As investors, however, we should be aware that there is a risk and like any risk, should not be ignored.

So what does this mean for your investment decisions? Probably, not much. If you're a savvy investor, then you already know that diversification is your best safety net. As long as you don't invest too much (proportionally) in any one type of asset, then you're unlikely to suffer a significant loss in even the worst of circumstances. Money market funds are a great safe bet. Just remember that safe doesn't equate with risk-free.