Not sure whether you can handle, emotionally or financially, the ups and downs of the stock and bond markets? You might want to place some of your money in a relatively stable investment such as money market funds. The returns are modest and it is almost impossible to lose your principal, hence money market funds are generally considered a safer form of investment than some others.

For most investors, money market funds are a small percentage of their total investment portfolio. The specific percentage—some financial experts say between 5 and 15 percent—may vary depending on the amount of safety or risk you are comfortable with.

What Are Money Market Funds?

Money market funds (MMFs), also called money market mutual funds and money funds, are types of mutual-fund investments that only invest in ultra short-term debt securities issued by banks, corporations, and federal, state, and municipal governments. These securities must have credit ratings with the highest quality and the lowest degree of investment risk. General Electric is one such corporation that issues these highest quality securities.

The primary purpose of money market funds is to limit exposure to risky investments. They are often offered through banks, brokerage houses, and mutual fund companies. Although money market funds are generally safe investments, potential investors should read the prospectus and consider carefully before investing in them.

Because they are considered a safe investment, money market funds are frequently used to make a modest return while maintaining the entire principal. In this way, short-term goals such as the purchase of a new automobile or a down-payment for a home can be attained. Many people try to maintain a three-to-six-month surplus of cash available in case of an emergency; a money market fund is a good way to do this.

Money market funds are also used to store money that has been received from the sale of another investment. Such “parking” of money can be helpful so that you can take some time to think about how, when, or whether to invest the money elsewhere.

A Secure History

Money market funds are issued and regulated under the guidelines set forth by the Investment Company Act of 1940, which is run by the U.S. Securities and Exchange Commission.

In 1970, American businessperson Bruce R. Bent established the first U.S. money market fund (“The Reserve Fund”). Throughout the history of money market funds, the Act has regulated thousands of them. For instance, section 2a-7 of the Act, which was enacted in 1983, states that all money market funds must be based on diversity, maturity, and quality. Specifically, the Act describes how money market funds must maintain a “weighted average maturity” of ninety days or less and cannot invest over five percent in any one issuing organization.

Today, the U.S. money market funds industry is worth over $3.1 trillion.

Key Components

Some important facts about money market funds are that they:

• Are totally liquid
• Have a stable share price (almost always US$1)
• Pay a higher rate than a general bank money market account
• Are highly regulated
• Have check writing and money transfer privileges
• Invest in very safe, short-term debt securities such as certificates of deposits and U.S. Treasury bills that typically mature in thirteen months or less
• Are not insured nor guaranteed by any federal government agency such as the FDIC (Federal Deposit Insurance Corporation)
• Are limited by federal regulations as to the number of electronic, telephone, and pre-authorized transactions per month
• Are restricted by various fees, limitations, and other minimum requirements

Taxable Versus Tax-free

Money market funds are generally divided into two categories: taxable and tax-free.

Taxable funds:

• Are funds whose interest is taxable
• Generally invest in short-term corporate or government securities
• Pay a higher yield than tax-free funds, but are not always the better investment

Tax-free mutual funds:

• Are exempt from federal income tax
• May be subject to local and state taxes
• Often invest in municipal or state securities
• Are sometimes a better investment for investors in higher federal tax brackets

To find out which is better for you, look into the “tax-equivalent yield formula.” The formula provides what percentage a tax-free fund needs to yield to earn the same as a taxable fund after taxes. The “tax-equivalent yield” equals “tax-free yield” divided by “1 – federal tax bracket.”

For example, if the taxable fund yield is 1.55 percent, the tax-free fund yield is 1.05 percent, and your federal tax-bracket is 28 percent, then 1.05 / (1-0.28) = 1.46. So, the tax-equivalent yield on the tax-free fund is 1.46 percent, while the taxable fund yield is 1.55 percent. In this case, you’re better off going with the taxable fund.

Additional Resources

-- iMoneyNet: http://www.imoneynet.com/

-- Money-Rates.com: http://www.money-rates.com/moneyfunds.htm

-- U.S. Securities and Exchange Commission: http://www.sec.gov/answers/mfmmkt.htm

-- U.S. Securities and Exchange Commission (Rule 2a-7): http://www.law.uc.edu/CCL/InvCoRls/rule2a-7.html

-- Investment Company Institute Web site about Money Market Funds: http://www.ici.org/funds/abt/adv_money_funds.html#TopOfPage

-- Investment Company Institute FAQ on Money Market Funds: http://www.ici.org/home/faqs_money_funds.html