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There's a bull market in fear right now, and investors are scurrying for cover. But one of the worst investments you can make right now is actually one you've been trained to think is a great safe haven with no risk at all.

Money for nothing
If you're looking for possible landmines in your portfolio, the last place you'd probably think to look is your money market mutual fund. After all, money market funds are designed to maintain a stable value of $1 per share, no matter what's going on with stocks, bonds, or other investments.

Despite their reputation, though, money market funds aren't the right place for your money right now. They're stuck between a rock and a hard place; the short-term securities they invest in are paying virtually no interest at all, yet many of them still have at least slight amounts of risk that could threaten their stability in the event of another financial crisis.

The unprecedented decision of the Federal Reserve to keep short-term interest rates at 0.25% or below for 18 months now has been a real headache to money market funds. Typically, funds earn enough in interest from their short-term investments to more than cover their expenses. That can make money market funds quite lucrative for fund managers, which charged an average of 0.34% per year to shareholders in 2009.

Now, though, it's a challenge to earn enough to cover even the full expense ratio, let alone have anything left over for shareholders. Treasury bills with maturities as long as 12 months in the future yield less than 0.25%, and while higher-risk commercial paper has somewhat higher rates, it still hasn't been enough in some cases to make up the difference. As a result, Charles Schwab (NYSE: SCHW  ) lost $113 million in potential profits during the second quarter alone from fee waivers, the sixth straight quarter it reported lost revenue from money market fund fees. Bank of New York Mellon (NYSE: BK  ) saw fee waivers at its Dreyfus funds rise in the second quarter.

Fortunately, it seems that most money market fund companies won't try to claw back those lost revenues from their customers. Northern Trust (Nasdaq: NTRS  ) and JPMorgan Chase's (NYSE: JPM  ) funds unit have stated that they have no ability to claim lost fees directly from shareholders. What funds may do, though, is hike their future fees once income levels rise enough to cover them.

In the meantime, though, money market funds are paying a pittance. Even those with extremely low expense ratios are paying 0.25% or less. And you can never be sure there won't be another problem like Lehman Brothers, which caused the Reserve Primary Fund to break the buck, and investors still haven't gotten all their money back from that money market fund.

Get paid what you're worth
What's especially surprising, though, is that you can get paid a lot better for taking less risk. The solution is simple: Use a high-yielding FDIC-insured savings account. Right now, the banking divisions of Sallie Mae (NYSE: SLM  ) , Capital One (NYSE: COF  ) , and Discover Financial (NYSE: DFS  ) offer rates of 1.35% or above, and a host of other institutions are paying more than 1% in interest.

That may not sound like much. But with these bank accounts, you don't have to worry about what toxic assets may be inside your money market fund. You also don't have to worry about whether your bank is making unsound investments, because in the worst-case scenario, the FDIC will make you whole up to its current $250,000 limit.

So whether you're scared enough of the stock market to want to move to cash, or you simply are keeping cash on hand in the hopes of picking up bargain stocks later, one thing is certain: Money you keep in a money market mutual fund isn't working as hard as it could for you. Increasing both your income and your safety factor is the right thing to do, at least until money market funds start paying you more than they are now.

Holding cash won't make you rich. Take a look at what Jordan DiPietro thinks is the best investing opportunity in a decade.

Fool contributor Dan Caplinger saved up a big pile of $1 bills from his grocery store tips. He doesn't own shares of the companies mentioned in this article. Discover Financial is a Motley Fool Inside Value choice. Charles Schwab is a Motley Fool Stock Advisor recommendation. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy knows when to hold 'em and knows when to fold 'em.

Read/Post Comments (6) | Recommend This Article (10)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On July 22, 2010, at 5:58 PM, KKnese wrote:

    A better, and less risky investment is US Government I series bonds. They're state tax free and they pay a minimum interest rate plus an inflation premium.

  • Report this Comment On July 23, 2010, at 10:20 AM, lctycoon wrote:

    KKnese, they are also much less liquid than a savings account (you can't get your money back for a couple years at least). The CPI number is flawed as well. How are they less risky? The US Government is backing those bonds. The US Government is backing your savings accounts.

  • Report this Comment On July 24, 2010, at 6:49 PM, guiron wrote:

    I prefer to ladder CDs to a pure savings account. However, if you're a little more bold you can invest in a mix of short-term treasurys, CDs and muni bonds. There are also several very stable tax-free funds, such as VWITX. Not as "safe" as savings, but it yields between 4% and 6.5

  • Report this Comment On July 24, 2010, at 6:54 PM, guiron wrote:

    Whoops ... yields between 4% and 6.5% from 1 to 10 years after tax and sales. That's far better than the 1.35% you are taxed as ordinary income on savings interest. But a fund isn't good for liquidity, so adding real savings mixed with laddered CDs can help but are obviously better when interest rates are higher. Most people don't need 8-12 months of savings immediately if something goes wrong, as long as enough is available month to month for a long period of time.

  • Report this Comment On July 24, 2010, at 7:57 PM, goalie37 wrote:

    Thank you for the article. Personally I never invest in a money market fund or any other type of fund. However, my ex wife recently started a 401k plan, and I was forced to choose between a very limited number of funds. With market instability, I didn't want her 100% in stocks. I am very, very fearful of the bond market right now, so the only option left was to put a percentage in a money market. Thank you for pointing out the risks here as well.

  • Report this Comment On July 27, 2010, at 1:53 PM, IlliniBanker wrote:

    lctycoon- yes, the FDIC backs your savings account. But if CPI goes to 5%, there's no guarantee that you'll be able to get 5% interest at the bank. We can debate about how the Fed sets up the consumer basket, but the bottom line is that it's a basket of real goods and there's an independent methodology for coming up with it.

    Unlike TIPS, Series I savings bonds offer an early withdrawal option (with penalty) after one year. However, you can't sell them for the first year. I use Series I savings bonds to help build up my emergency savings over the course of a year, but not as a retirement investment and not as a place to stick money for less than a year.

    Dan- also offers CDs with a 60-day early withdrawal penalty. So if you want to lock in a 4-5-year rate, but you're not 100% sure you won't need money before then, that might also be a good option.

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