When you’re building your savings and investment portfolio, it’s important to consider including a wide variety of assets at different risk levels. A money market fund is a type of mutual fund that invests in debt securities with short maturities and minimal credit risk.

Like other mutual funds, money market funds can provide diversification to your investment portfolio and the ability to grow your money. However, they tend to have lower risk levels and lower growth potential than other mutual funds.

Money market funds can be a valuable addition to your investment portfolio. Keep reading to learn more about how these funds work and why you might want to invest in them.

How money market funds work

A money market fund is a type of mutual fund, meaning it’s a pooled investment that takes the money of many different investors and invests it in a variety of assets. Money market funds invest in high-quality, short-term debt securities, meaning they are generally low risk compared to other mutual funds.

Some of the assets you might find in a money market fund include:

• U.S. Treasury securities
• Municipal securities
• Certificates of deposit
• Repurchase agreements
• Commercial paper
• Corporate notes

Money market funds come in many different forms. Some invest entirely or primarily in U.S. Treasury securities, while others invest primarily in private assets, including certificates of deposit, repurchase agreements, corporate notes, and more.

Money market funds can be either taxable or tax-exempt, depending on the assets they invest in. Tax-exempt funds invest in municipal securities, so you won’t have to pay federal income taxes on the earnings from those funds. Other money market funds are taxable, meaning you’ll pay income taxes on the income you earn from them.

Money market fund vs. money market account

Many people confuse money market funds with money market accounts. While their names are very similar, the two are not the same. While money market funds are registered mutual funds, money market accounts are deposit accounts that you can open with banks.

Money market accounts combine the features of savings and checking accounts, allowing you to earn interest on your savings while also having check-writing or debit card privileges.

While money market accounts often earn more than standard savings accounts, their earnings are still likely lower than a typical money market fund. One of the most important differences between the two is that money market accounts are typically FDIC-insured up to FDIC limits, meaning you don’t have to worry about losing your money. Money market funds, on the other hand, aren’t FDIC-insured.¹

Why invest in money market funds?

Money market funds offer a few key benefits that make them an attractive investment option.

Diversification

First, money market funds make it easy to diversify your investment portfolio. If your asset allocation primarily includes stocks and long-term bonds, money market funds and the short-term debt securities they hold can offer some low-risk diversification. Additionally, money market funds themselves are diversified since they invest in many different underlying assets.

Stability and low volatility

Money market funds are among the least volatile investments. Thanks to the high-quality debt securities they invest in, they provide more stability than stocks and other bonds. While you may not see high returns in money market funds, money market funds help protect your savings.

Interest-earning potential

Money market funds invest in debt securities that pay interest. Unlike stocks, which primarily offer capital appreciation, this interest income can either be reinvested or deposited into your bank account to create an additional source of income. These interest rates are usually competitive with or slightly higher than those of high-yield savings accounts or money market accounts.

Accessibility and liquidity

Money market funds are highly accessible and liquid, meaning you can quickly convert your investment to cash with little wait. Similarly, because the money in a money market fund is so accessible, you can easily use it to purchase new investments when the opportunity arises. In fact, money market funds are frequently used within brokerage accounts to hold cash reserves. In other words, the money you transfer to your brokerage account is automatically held in a money market fund until you direct it elsewhere. The accessibility and liquidity of money market funds can make these investments suitable for holding a portion of your emergency funds or money for short-term goals, like an upcoming renovation.

Read more: How to keep your cash safe right now

Cost-effectiveness

Unlike many other investments, money market funds generally don’t charge fees for purchasing or redeeming shares. This lack of fees helps make money market funds cost-effective, especially if you’re depositing or withdrawing money regularly.

Tax benefits

Money market funds that hold only municipal securities are exempt from federal taxes and state taxes in the state the municipal securities are issued. This can be especially beneficial for high-income investors looking to reduce taxes on their investments. Additionally, these tax-exempt funds can be a good addition to your taxable brokerage account while you put your less tax-efficient investments in a tax-advantaged retirement account.

Understanding the downsides of money market funds

Money market funds have some key benefits. However, there are also a few downsides, and it’s important to understand them before adding these funds to your portfolio.

Lower long-term returns

Money market funds will generally have lower long-term returns than other investments, especially stocks. It’s an expected trade-off of a lower-risk investment.

While money market funds can provide diversification and risk mitigation to your portfolio, they typically don’t yield enough to make up your entire portfolio, especially for long-term savings goals like retirement. Young investors especially may benefit more from equity mutual funds, despite their higher risk, due to their potential for higher returns. A young investor has a longer time horizon and more time to recover from market downturns, so they can afford to take on more risk.

No capital appreciation

Unlike equity investments, money market funds don’t offer the benefit of capital appreciation. When you buy a stock, you hope that its value will increase over time. Then, when you sell the stock down the road, you would hope to get a profit from its capital appreciation.

Because money market funds invest in short-term debt securities, you don’t get this same capital appreciation. As a result, there’s not necessarily more benefit the longer you keep your money in the fund.

Investment risk

Though money market funds have less risk than most other assets, they still have some investment risk. Corporate debt securities are subject to credit risk, which is the risk that the debt issuer will default.

A money market fund aims to maintain a net asset value (NAV) of $1 per share, though there is no guarantee.² Any excess earnings that get generated through interest on the portfolio holdings are distributed to the investors in the form of dividend payments.

The risks you’re most vulnerable to are those associated with these funds’ low returns. For example, you face inflation risk, meaning the fund’s returns could be lower than the inflation rate.

How to buy money market mutual funds

Are you considering investing in money market funds? Here’s how to get started:

1. Choose an account type

First, you’ll have to decide what type of account to invest in. You can invest in money market funds via a taxable investment account or directly through the mutual fund. For taxable funds, you can invest in either a taxable investment account or a tax-advantaged retirement account like a 401(k) plan or an individual retirement account (IRA).

Read more: The advantages of an IRA

2. Open an investment account

If you don’t already have an account through a financial institution or directly with the fund, you’ll have to do that first. There are many different providers available, and you may even be able to purchase these funds through your bank’s broker-dealer affiliate.

Read more: The basics of brokerage accounts

3. Determine how much to invest

The next step in investing in money market funds is determining how much to invest. First, keep in mind that many funds require a minimum deposit, which will impact your investment amount.

When considering how much to invest in a money market fund, consider what percentage of your portfolio you want in these funds. If you’re a young investor, you probably want only a small portion of your portfolio in lower-risk funds like these. However, if you’re older and closer to retirement, you may feel most comfortable investing more in money market funds.

4. Choose a money market fund

There are many money market funds on the market, and it’s important to choose the one that best fits your needs. Common fund types include:

• Government funds: A government money fund invests at least 99.5% of its total assets in cash, government securities, and repurchase agreements that are fully collateralized by cash or government securities.³
• Treasury funds: A Treasury fund invests in standard U.S. Treasury-issued debt securities, such as Treasury bills, Treasury bonds, and Treasury notes.⁴
• Prime funds: Also known as general purpose funds, these invest in many types of debt securities, including corporate and government securities.
• Municipal funds: Municipal funds are tax-exempt funds that invest in municipal securities.⁵

5. Place your buy order

Once you’ve identified a money market fund to buy, you can go ahead and purchase your shares. If you feel comfortable doing so, you can set up an automatic investment, so you won’t have to purchase the funds manually in the future.

6. Reevaluate your investments

Once you invest in a money market fund, don’t just forget about it. Instead, it’s important to revisit and evaluate your portfolio on a semi-regular basis. Consider reevaluating your money market fund investments at the same time you look at and rebalance your entire portfolio.

The bottom line

Money market funds aren’t as flashy and exciting as equity investments, but they still make an important addition to any investment portfolio. Thanks to their lower level of risk, money market funds can help diversify your portfolio and mitigate some of its risks. Just like any other investment, money market funds have both pros and cons that any investor should understand before purchasing them. Working with a trusted financial professional can help you to make informed investing decisions.