The Illusion of the "Safe Money Market"

Last Updated Mar 21, 2011 9:44 AM EDT

With the stock market so volatile and the threat of a bond bubble popping, many investors are turning to what they think is the safety of a money market fund. Sure, if your money market is at a bank or credit union and you stay below government FDIC or NCUA insurance limits, there is no default risk. In my opinion, however, you are taking the ultimate risk anyway and are guaranteed to lose purchasing power.

Inflation is again rearing its ugly head
I'm guessing you've noticed the price of gasoline and food has skyrocketed. According to the US Bureau of Labor, the Consumer Price Index (Urban) has increased 2.1 percent over the past 12 months. I can assure you that the inflation hitting my wallet is much higher given healthcare, energy, and education increases. Thus, any money tucked away earning a stellar 0.1 percent lost at least two percent in purchasing power.

And if inflation goes up, things could get worse. Let's say inflation goes to six percent and money markets start paying three percent. The $100,000 you've stashed in a money market will pay you $3,000. Uncle Sam takes a third leaving you with $2,000, or a two percent after-tax return. Now you've lost four percent purchasing power given this six percent inflation.

The Frog in the boiling water
The saying goes that if you put a frog into boiling water, it will quickly jump out. But if you put the frog in a pan of cold water that is being slowly heated, it will not realize the change in environment and will be boiled to death.

While I sincerely hope nobody has actually conducted such a sadistic experiment, you can guess where I'm going with this analogy. Investing in equities, and to an extent bonds, gives us immediate feedback of the environment and we quickly jump out, though it's usually the wrong thing to do.

The money market gives us the less-threatening feeling the frog must have felt in the cool water. Unfortunately, we don't notice our purchasing power being eroded, month by month, and suffer the fate of being able to do less with our nest egg.

Two implications for investors
The first implication is that you need to reframe your choices of which you have two. One choice is to take some risk and have a shot at beating inflation and growing your portfolio. The alternative is to virtually guarantee a loss of spending power.

The second implication is not to settle for an average money market account. The best deal around to stash your cash today is actually a five year CD at Ally Bank. Because of its easy 60 day early withdrawal penalty, taking the cash out after four months and paying the penalty still yields more than any money market.

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  • Allan Roth On Twitter»

    Allan S. Roth is the founder of Wealth Logic, an hourly based financial planning and investment advisory firm that advises clients with portfolios ranging from $10,000 to over $50 million. The author of How a Second Grader Beats Wall Street, Roth teaches investments and behavioral finance at the University of Denver and is a frequent speaker. He is required by law to note that his columns are not meant as specific investment advice, since any advice of that sort would need to take into account such things as each reader's willingness and need to take risk. His columns will specifically avoid the foolishness of predicting the next hot stock or what the stock market will do next month.

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