The compounding power of time and money is amazing. Is a money market account best for your needs?
When looking for a low-risk place to stash their savings, many people turn to money markets. But before you go hunting down the highest rates and the best terms, there are two things you need to consider. After a little research you may even find that a money market isn't even the right investment vehicle to help you achieve your financial goals.
1. What do you intend to do with this money?
Everybody wants to keep their money safe and growing, but only when you are specific about what you are trying to accomplish, -- i.e., establishing an emergency fund, saving for retirement, or setting aside cash for a child's college fund -- can you really make the the best decisions.
Losing value to inflation is a risk with money markets. Source: TaxRebate.org.uk via Flickr.
A money market account is great as an emergency fund or a temporary home for excess cash, but it's a terrible account for daily spending due to the Federal Reserve restrictions on the number of transactions you can make.
If frequent access to your cash is what you need, your best bet -- even though you'll probably get a smaller yield -- is an interest-bearing checking account. A number of online-only banks offer checking accounts that pay slightly better yields than traditional banks. Bank of Internet (AX 0.72%) offers up to 1.25% yield, while Capital One Financial's (COF 3.55%) Capital One 360 has yields up to 0.8% on checking. A little research can help you find the best return based on the balance you'll carry.
However, if you're looking to save and grow the money for a need many years in the future, such as a child's college tuition or your retirement, then interest-bearing accounts of any kind -- whether savings, money market, or CD -- usually aren't the best way to save money.
2. Is this the right savings vehicle to help you achieve your goal?
While savings vehicles such as money markets might seem like the safest place for your money, that's not necessarily the case for long-term savings growth. The reality is that saving money in a money market or savings account for the long term, based on the low rates available today, actually reduces the spending power of your money over time.
Today's rates -- at or below 1% -- won't even keep up with inflation, meaning the spending power of your cash will decrease even as the dollar balance goes up. As a comparison, the stock market rises about 9% per year, on average, over long time periods -- well above the best money market rates and far outpacing inflation.
Before you click away, I know what you're thinking: The stock market is way too risky. It goes up and down all the time. That's true in short periods, but over longer periods, your risk of losses from volatility declines. This is where time -- the advantage for small-time savers like you and me -- is in your favor.
Let's look at the historical evidence.
Needless to say, the dot-com crash caused a lot of losses for anyone who bought at the peak and sold at the bottom. But when you take the long-term view -- which is what you should do if you're planning to use your savings many years down the road -- those who invested and stayed invested have still done well:
Why does this happen? It's really pretty simple.
When you put money in a savings vehicle like a money market or savings account, the bank where your money resides gets a little more lending power from your deposit, and it pays you a (very small) portion of what it earns from that money. Today's low-interest-rate environment means even lower returns for savers.
But when you invest your money in the stock market, you are literally buying part of a business, which means you share in both the profits of that company and the increased value of that business as it grows over time. Even when the market is down, you still own part of that business. The best businesses are resilient and will more than recover value lost in market downturns.
So, where should you put your money?
Source: SeniorLiving.org via Flickr.
For many people, the best way to save money for those long-term needs is by investing in low-cost index funds, such as those in the chart above.
The Vanguard Total Stock Market ETF (VTI -0.21%) is the low-cost ETF version of the Vanguard Total Stock Market Index Fund (VTSMX -0.61%) mutual fund in the chart and gives you broad exposure to a wide representation of the U.S. stock market.
This means wide diversity without having to handpick companies to invest in, paying very little in management fees, and having a high likelihood of earning much better long-term returns than you would with a money market account.
Furthermore, you can use a number of account types to reduce your income taxes today or grow college savings tax-free. In many cases, the tax-deferral value of these accounts can be worth more than you get from a money market alone.
A money market account might still be the right place for your money, but don't assume that it's automatically better or safer, especially if you're putting money away for long-term needs.
