Money market funds are widely considered to be some of the most conservative and least risky investments. They are typically structured as open end funds which hold liquid assets such as short term loans and obligations. Specifically, their holdings tend to consist of treasury bills and commercial paper which have maturities of less than a year. Such funds are taxable at the federal level. In some cases the funds are composed of municipal securities with short time horizons (less than a year). Such municipal funds are typically exempt from taxation at the federal level and are suitable for investors in higher tax brackets.
Money market funds are liquid and can typically be converted to cash within one business day. They are suitable for investors with very short time horizons (less than a year) and low risk tolerance. They are frequently used to fund short term needs such as emergency funds and current liabilities.
Money market funds held at banks are typically insured by the FDIC (Federal Deposit Insurance Corporation) and are considered as safe as bank deposits. Most, but not all, money market funds held in brokerage accounts at broker-dealers are not FDIC insured. These non-insured funds are generally considered to be low risk, however investors should be aware that they are not as safe as FDIC insured bank deposits.
Banking products, such as checking accounts, savings accounts, and certificates of deposit (“CDs”), are designed to serve a variety of purposes for consumers and businesses who utilize these products. A checking accounts is designed to conduct transactions, while savings accounts and CDs are designed for the storage of short term and medium term cash reserves. For an individual or family cash reserves are oftentimes maintained as an emergency fund or to fund short term or medium term financial needs or objectives.
A checking account is designed to conduct a larger volume of transactions than a savings account. There is typically no limit on the number of monthly transactions in a checking account; banks may even encourage a larger volume of transactions through various means. Checking accounts may have higher fees, and typically pay lower interest rates than savings accounts. They are designed to fund immediate financial needs.
A savings account typically has a lower fee and pays a higher rate of interest than a checking account, and is designed to be accessed and transacted in by the account holder less frequently. There may be monthly limits on the number of transactions which can be conducted, or additional fees if certain transaction limits are breached. These accounts are designed to fund short term financial needs.
Certificates of deposit
A certificate of deposit, or CD, is designed as a vehicle to store cash for a medium term need, typically 3-12 months, although banks frequently issue CDs for much longer time periods than this. In a CD a fixed sum is deposited into the product and can not be accessed for its duration without subjecting the depositor to a withdrawal penalty. The interest rate on a CD is typically higher than that of a savings account, and tends to increase along with the duration of the particular CD product. In some cases, the bank will pay a higher interest rate if the deposit size exceeds a certain amount.
An emergency fund consists of cash assets held in savings accounts, checking accounts, money market accounts, or CDs for the purpose of meeting unexpected expenses. How much of an emergency fund you should maintain varies depending on a variety of factors including the amount of your income and the stability of that income. Having more reserve assets than necessary can deprive you of the opportunity to earn a substantial rate of return on your liquid assets, while having an inadequate amount of cash reserves can subject you to the risk of having a cash shortage should an unexpected emergency event arise.
On one end of the spectrum is an individual or family with steady, predictable income. A family in this situation could likely survive with an emergency fund consisting of three months living expenses. On the other end of the spectrum is an individual or family which relies on business or self employment income. Such a family would likely require a much larger emergency fund, consisting of as much as twelve months of living expenses.
It is also important to perform a risk analysis to determine the likelihood of an emergency event occurring and the risk management systems in place to plan for the possibility of such events occurring. This includes analyzing existing insurance coverage with respect to coverage amounts as well as deductibles, as well as cash reserves held in vehicles such as health savings accounts. For example, individuals or families who self insure will need to maintain a higher cash reserve in an emergency fund than those individuals or families who maintain a substantial amount of insurance. Similarly, having insurance coverage with high deductibles will necessitate having sufficient cash reserves to pay those deductibles should a claim arise.