One thing that I’m a tad ashamed to admit (but will do so anyway to generate a good intro for my investment-related topic) is that I am scared of heights. You’ll certainly never catch me sky diving or bungee jumping, but even mundane things like ladders and balconies freak me out a little bit. No one but my wife really knows this, but I suppose that’s changed now with this white paper being distributed to thousands of people.

It’s really not that big of a deal; everyone fears something. However, my shame has less to do with the fact that I’m afraid of something and more to do with how this fear renders me senseless and irrational at times. Take flying for example. I do it—maybe two or three times per year—but it still makes me nervous. Why? Because planes go really high. I’m not acrophobic by any means; I manage. But I get a bit uneasy thinking about being so high off the ground, so I take my mind off it by reading, sleeping, or watching a movie.

What bugs me about my anxiety towards flying is that I know it’s safe. What bugs me more is that I’m not scared to ride in a car, which in comparison is a much riskier way to travel. In his book Culture of Fear, Barry Glassner, a professor of sociology at the University of Southern California, explores why Americans often fear the wrong things. In the first edition, published in 2000, regarding my fear of airline travel, he writes:

“In the entire history of commercial aviation . . . fewer than 13,000 people have died in airplane crashes. Three times that many Americans lose their lives in automobile accidents in a single year. The average person’s probability of dying in an air crash is about 1 in 4 million, or roughly the same as winning the jackpot in a state lottery.”

 I like to think of myself as a rational person. My job as Chief Investment Officer demands that I be. Emotional investing is bad investing, so I strive every day to make solid, well-thought decisions based on facts, data, and probabilities—and I encourage my clients to do the same. Yet, here is this one aspect of my life in which I’m completely irrational. I know the facts and have considered the data and probabilities. In fact, they are printed right above. Regardless, when I hop on a flight to Chicago next month, I know I’ll immediately be looking for the drink cart to calm my nerves.

Breaking the Buck—The Irrational Fear of Money Market Funds

Few in our industry will forget the day that Lehman Brothers filed for bankruptcy. I know I certainly won’t. It was September 15, 2008, and as far as I’m concerned it was the triggering event that sent the stock market from correction to crash. As a result of the Lehman failure, the very next day the Reserve Primary Fund, the oldest money market fund in the United States, broke the buck when its shares fell from $1 to $0.97 after writing down the Lehman debt it held.

Panic ensued in the following days as investors pulled significant assets out of money market funds, questioning their safety. Left unchecked this run on money funds could have resulted in a snowball effect in which investor redemptions forced funds to sell more securities into a declining market, which would have in turn increased the probability of more funds breaking the buck, leading to more investor panic and so on. To quell the panic, the U.S. Treasury stepped in to insure money market funds, which succeeded in stabilizing the money market by restoring investor confidence and stopping the outflows.

Although it may not have seemed like it at the time, or even still today given the recency of events, the phenomenon of money funds breaking the buck is incredibly rare. Within the United States, money market funds have been around since 1971, and there have only been two instances in which a fund broke the buck—the aforementioned incident with the Reserve Primary Fund in 2008 and the Community Bankers U.S. Government Fund in 1994. And in both cases the losses to investors amounted to just a few pennies on the dollar—3% in the case of Reserve Primary and 4% with Community Bankers.

The Unseen Risk of Money Market Funds

The Unseen Risk of Money Market FundsAs evidenced by the events of September 2008, it is obvious that among the investing public’s greatest fears is waking up one day to find that their money has vanished, especially the portion of their investments that they consider safe (i.e., their cash). When taking into account the rarity of failed money funds and the relatively small losses that occur when they do fail, it is difficult to imagine a realistic scenario in which investors’ worst fears would be realized. However, as we know from my personal introductory admission, our fears don’t always allow us to think rationally, which is why we often overestimate and dwell on the benign risk (air travel) and underestimate or ignore the more serious risk (automobile travel).

With that in mind, I’m about to share with you the real risk of money market funds, a decision that I hope won’t cause a panic. Your money market fund is losing money. It lost money in 2009, and it is very likely to lose money again in 2010. It won’t make news by breaking the buck, but your investment will be worth less and less with each passing month.

As the adjacent table illustrates, the real (after-inflation) return on money market funds was negative in 2009 and in the first quarter of 2010. With money market yields near zero and likely to stay there for the near future, this situation is not likely to change anytime soon. Even with mild inflation, which we are experiencing now, money market funds will continue to lose money. If inflation picks up in the coming years as many, including us, expect it will, we could be looking at money market losses of around 5% per year. While money fund investors won’t awake one morning to news of their cash holdings having disappeared, a slow bleed of purchasing power amounting to losses of a few percentage points per year is probably not what investors had in mind for the “risk-free” portion of their portfolio.

The Money Illusion

The Money Illusionn the early 20th century, the famed economist John Maynard Keynes coined the term “money illusion” to refer to the fact that people tend to think in nominal (pre-inflation) terms rather than real (after-inflation) terms. As a result of this mental blind spot, people tend not to factor inflation into their decisions about money and investing.

Consider the study appropriately titled “Money Illusion” by Eldar Shafir (Princeton University), Peter Diamond (M.I.T.), and Amos Tversky (Stanford University) that was published in the May 1997 edition of The Quarterly Journal of Economics. In the study, they asked their subjects to review a hypothetical situation in which three individuals—Adam, Ben, and Carl—each made a real estate investment during a different economic environment: one with significant inflation (Carl), one with no inflation (Ben), and one with significant deflation (Adam). The returns of their individual investment activity were presented in the following manner:

The subjects were then asked to rank Adam, Ben, and Carl in terms of the success of their investment, with #1 being the person who made the best deal and #3 being the person who made the worst deal. The most frequent response was:

1. Carl
2. Ben
3. Adam

As you can see, the most typical ranking coincided with who did the best in nominal terms. Carl had a 23% gain on his investment, so most subjects in the study felt that he did the best. Adam lost 23% on his investment, so most subjects felt that he did the worst. However, what most of the subjects failed to factor in was the effects of inflation or deflation on their investments. Carl may have gained 23% on the sale of his home, but it occurred during a period of 25% inflation, which resulted in a real loss of 2%. Adam’s home fell 23% in value, but it occurred during a period of 25% deflation, which resulted in a real gain of 2%. The correct order is based on the performance of the investment in real terms, which factors in the effects of inflation and deflation, and is hence:

1.   Adam
2.   Ben
3.   Carl

Overcoming the Money Illusion

In a normal investment environment, you can often get by without ever thinking about the effects of inflation on your cash. From 1994 to 2001, the return on the 30-Day Taxable Money Market Index exceeded inflation by at least 1% each and every year. The same thing occurred between 1981 and 1991. Risk-free investments like money markets typically pay slightly more than inflation in normal market environments.

Obviously, the investment and economic environment we find ourselves in today is anything but normal. Short-term rates are nearly zero percent and are likely to stay that way for an extended period of time. The Federal Reserve is notoriously slow to raise interest rates during the early stages of economic recovery. The last time short-term rates were anywhere near this level was in late 2003 and early 2004 in response to the recession of 2001. Despite the fact that the recession ended in November 2001, the Fed did not begin raising rates until July 2004, a full two and a half years after the end of the recession. This time around, given the Fed’s history and the unwanted political implications of raising rates in the face of 10% unemployment, it is unlikely that short-term rates will move higher anytime soon. That means that if you want to avoid continued losses on your cash you will have to overcome the money illusion and start to seek out positive real returns.

Bell’s Cash Reserve Strategy

In response to negative real returns on cash investments, we developed a Cash Reserve Strategy for our clients last year. Rather than be forced to watch their cash reserves in money market funds slowly lose purchasing power month after month, we decided to employ the use of high-yield savings accounts, CDs, and short-term bond funds to help boost the yield on their cash to a level more likely to keep pace with inflation.

 With CDs, you give up the luxury of one-day liquidity that money markets offer. With short-term bond funds, you give up the security of a stable NAV. However, in a market with zero-percent short-term rates, you will have to experience a certain level of inconvenience and discomfort to protect the value of your cash. In both cases, we feel that the costs are worth the benefit, as the yield pickup can be significant.

High-Yield Savings Accounts

These are savings accounts typically run by online banks. The accounts are electronic and simply link to an existing checking or brokerage account. Because these online banks don’t have branches, their reduced overhead allows them to pay out more in yield than traditional banks.

This type of investment is ideal for emergency cash—the cash that you’ll need to cover living expenses for a period of time if you lose your job or if the market drops and you don’t want to be forced to sell assets into a declining market to generate income. It also serves to cover life’s unexpected events like the new roof on your house or that unforeseen tax bill.

High-yield savings accounts are ideal for emergency funds because they are safe (FDIC insured up to $250,000) and liquid. The money will be easily accessible when you need it, which is important because you don’t know when you’ll need it. That’s the fun with emergencies.

We typically recommend that our clients maintain at least six to twelve months of living expenses as emergency cash. As of the time of this writing, the high-yield savings accounts that we have recommended to our clients yield between 0.5% and 1.3%. While that’s not likely to keep up with inflation, the primary objective for emergency funds is safety and liquidity, so yield is a secondary concern. However, while these accounts offer a major yield pickup over money markets, the fact that the rates are still below inflation means that you should not keep more than twelve months worth of living expenses in this type of vehicle.

CDs

With CDs you can get a little more in yield than high-yield savings accounts, but it comes at a price—liquidity. Because they are illiquid and because there are penalties for early termination, you only want to utilize CDs for cash that you know you won’t need for a period of time. Have a financial commitment coming up in a year? You could use a CD to fund that liability now and pick up a slight amount of yield over high-yield savings accounts. As of the time of this writing, we found a few banks offering one-year CDs paying around 1.5%.

Short-Term Bonds

In working with our clients to maximize the yield on their cash reserves, we’ve consistently found that many people have too much cash. By “too much” I mean cash in excess of twelve months worth of living expenses plus any near-term financial commitments. As we mentioned above, you should only utilize high-yield savings accounts and CDs for cash needed within the next year; otherwise, your cash is still losing some of its value to inflation.

For this “excess” cash, we have been recommending that our clients use short-term bond funds. Now unlike bank accounts or CDs, this involves some risk; however, we feel the risk is justified given that these funds give us the best chance to keep pace with or even beat inflation.

The question we receive most regarding this strategy is, “Won’t I lose money when interest rates start to rise?” To which we respond, “You’re already losing money to inflation.” Rising interest rates are a risk as bond prices move inversely with interest rates, but the timing, extent, and severity of rate rises are all big unknowns that will ultimately determine how bond prices react. Short-term bond funds offer some protection against rising rates because of the low duration of their portfolios—the lower the duration, the less sensitive the portfolio is to changes in interest rates.

And while interest rate risk certainly exists and should be accounted for, inflation is the clear and present danger to your dollars. Rising rates may cause short-term bond funds to decline in value in the future, but inflation is already eating away at your cash.

As an added bonus, for investors in higher income tax brackets, we have been utilizing tax-free bond funds that invest in short-term municipal securities to help improve the yield via a lower tax bill. Although I suppose that money market funds should be considered tax-free securities as well these days given that they pay nothing.

Conclusion

Investing always requires a lot of work. In the past, that was usually not the case with investing your cash: you’d buy a money market fund, pay a small fee, and collect yield payments that kept your cash growing slightly ahead of inflation while enjoying one-day liquidity from an investment with a stable value.

Unfortunately, those days are no more. They’ll certainly return at some point, but for the time being, the conditions are such that your cash in money market funds is losing value month after month. To maintain the value of your cash, it is going to take a willingness to take a small amount of risk, and it is going to take a lot of work to scour the financial markets for the best risk-free yields and the safest short-term bond funds. So, if you find yourself sitting on a large pile of cash that you now realize is losing money, don’t panic. Give us a call. We’re here to help.