With money market funds currently offering a substantial 5% yield and the increased level of volatility in the stock market, it’s natural to question the necessity of diversifying into other asset classes. We certainly recommend having an allocation to cash and other safe investments as part of your overall portfolio. However, while money market funds can indeed provide a stable return, a comprehensive investment strategy often demands a broader approach. Let’s explore the importance of diversification and the benefits of investing in other asset classes despite the current attractive yield of money market funds.
Understanding Money Market Funds
Money market funds are often thought of for their stability and liquidity. They invest in high-quality, short-term debt instruments such as government securities, certificates of deposit, and commercial paper. The primary objective is to preserve capital while providing modest returns.
Their appeal lies in their low risk and steady returns, making them a preferred choice for investors seeking safety and liquidity. With the Federal Reserve increasing interest rates in recent years to levels not seen in decades, and funds offering yields exceeding 5%, the amount of assets in these funds reached an all-time high of $6.5 trillion in January 2024. However, over longer periods of time money market returns are typically lower compared to other investment options.
The Case for Diversification
Risk Management: While money market funds offer stability, relying solely on them can expose your portfolio to certain risks. Changes in interest rates or inflation can especially affect the returns of these funds. With inflation moderating and the Federal signaling interest rate cuts in the near future, the yield on money market funds is likely to drop. As the chart below illustrates, fund yield is highly correlated with the Effective Federal Funds Rate set by the Federal Reserve. Diversifying into other asset classes can help mitigate these risks by spreading your investments across different sectors and markets.
Potential for Higher Returns: While money market funds provide a consistent yield, other asset classes such as stocks, bonds, and real estate have the potential for higher long-term returns. For example, our next – 10 year expected return on a diversified balanced portfolio is about 7.40%, whereas we expect cash & equivalents to return about 3.15%. Although they come with greater volatility, a well-diversified portfolio can capture upside potential while minimizing downside risk.
Next – 10 Year Return Estimates for Selected Asset Classes
Inflation Protection: Inflation erodes the purchasing power of money over time. While money market funds offer stability, they may struggle to keep pace with inflation, especially during periods of higher inflation. Investing in assets like stocks or real estate, which historically have demonstrated the ability to outpace inflation, can help preserve the value of your wealth over the long term. The chart below shows that over the last 20 years $1000 invested in a balanced portfolio would have grown to $3200, while the same $1000 in a money market fund would have grown to $1,382 as of January 2024. The chart also shows that $657 of purchasing power would have been eaten by inflation. This means the inflation adjusted value of the original $1000 invested in a balanced portfolio would equate to $2543 and $725 if invested in a money market fund!
Capital Appreciation: Unlike money market funds, which focus on preserving capital, other asset classes offer the opportunity for capital appreciation. Stocks, for example, represent ownership in a company and have the potential to increase in value over time as the company grows and generates profits. By diversifying into growth-oriented assets, you position your portfolio for potential long-term capital growth.
Income Generation: Beyond yield, other asset classes can provide alternative sources of income. Dividend-paying stocks and bonds, for instance, offer regular income streams in addition to potential capital appreciation. Real estate investments, such as rental properties or real estate investment trusts (REITs), can also generate rental income, providing a steady cash flow.
Conclusion
While money market funds offer stability and liquidity, a well-rounded investment strategy should encompass a diverse range of asset classes. Diversification is key to managing risk, maximizing returns, and achieving long-term financial success. By allocating investments across stocks, bonds, real estate, and other asset classes, investors can build resilient portfolios that can weather various market conditions and provide opportunities for growth and income. While the current yield of money market funds may be appealing, it’s essential to consider the broader investment landscape and the role of diversification in achieving financial success.