Money Markets: How Safe Is Your Cash?
by Alexander Green, Chairman, Investment U
Investment Director, The Oxford Club
Monday, September 22, 2008: Issue #858
Last week investors panicked. You can’t really blame them considering the state stocks and money markets were in:
- A 158-year-old investment bank failed.
- The nation’s largest brokerage rushed into the arms of Bank of America to stave off a similar fate.
- The world’s largest insurance company was on the verge of going belly up before Uncle Sam showed up at its bedside.
- And the country’s oldest money market fund - the Reserve Primary Fund - “broke the buck,” handing back shareholders less than a dollar a share.
Apparently, investors found this last development the most unnerving of all. To paraphrase Mel Brooks: Fat-cat bankers and brokers losing their multi-million dollar jobs is comedy. Me getting back 97 cents on the dollar is tragedy.
Of course, one expects to get less out of a money market than he put in, no matter how pitiful the yield.
But Reserve Primary owned a slug of commercial paper (i.e. short-term debt) issued by Lehman Brothers. And Lehman, of course, filed for bankruptcy earlier in the week.
A couple of days later, Putnam Investments closed one of its money market funds because of a run of withdrawals, even thought the fund hadn’t lost any of its shareholders’ money.
Thousands of investors woke up to the fact that money market funds don’t come with a principal guarantee, government or corporate.
At least… they didn’t until last week.
Treasury Department Insures Money Market Funds
On Friday, the Treasury Department announced that the government for the first time would insure money market funds to discourage investors from pulling trillions of dollars out and creating financial chaos in the process.
That calmed things down. Prior to the announcement, investors pulled more than $220 billion from money market funds last week.
How safe is the cash you hold in a bank or brokerage firm that is outside of a money market account? Pretty darn safe.
The Federal Deposit Insurance Corp. (FDIC) guarantees bank deposits up to $100,000 per person, per insured institution. (So if you and your spouse have a joint account, for example, you’re insured up to $200,000.)
If your bank fails, you may have a period where you cannot access your money, but Uncle Sam will make sure you get your principal back.
The cash (and other securities) in your brokerage account are insured by Securities Investor Protection Corporation (SIPC) up to $500,000. When a brokerage is closed due to bankruptcy or other financial difficulties, SIPC steps in and returns your cash and other securities.
From its creation by Congress in 1970 through December 2007, SIPC advanced $508 million to make possible the recovery of $15.7 billion in assets for an estimated 625,000 investors. (Bear in mind, this is protection against your broker going out of business, not the companies you invested in.)
So heave a sigh of relief. But don’t get too comfortable.
U.S Government, FDIC, and SIPC are Protecting Your Cash
Yes, the U.S. government is protecting the money in your money market account - for now. And the FDIC and SIPC are protecting your other cash.
But for a few days last week, the financial markets were coming apart at the seams. The Federal government rushed out a bailout plan (details pending) and suddenly the stock market shouted “Hallelujah!”
But don’t uncork the good champagne just yet. I believe the worst is behind us for now. But this financial crisis isn’t over.
Confidence has been badly scarred. Investors have gazed over the edge of the precipice and gotten a serious reality check. Many more families are now thinking in terms of return of capital rather than just return on capital.
The financial markets will rise again. At some point they will rise dramatically, as they always do after a crisis. But first there has to be a healing process.
As James Madison said a couple hundred years ago, “The circulation of confidence is better than the circulation of money.”
And in today’s complex, interrelated financial markets, you simply won’t have the latter without the former.
Good Investing,
Alex
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Today’s IU Crib Sheet
Successful investing boils down to combating uncertainty. And while there is no way to avoid this risk, you can certainly mitigate it… and actually use it to your advantage.
Just take a look at the first of our Four Pillars of Wealth. It will not only reduce your overall investment risk, it will actually increase your total return. No other investment strategy can boast the same. That’s why this strategy earned a Nobel Prize. And that’s why we made it the foundation of our investment philosophy at The Oxford Club, Investment U’s premium service.
Our second “Pillar of Wealth” deals with having - and adhering to - a sell discipline. Everyone knows you should cut your losses early, and let your profits run. Well, the only way to consistently do both is to use a 25% trailing stop. It defines an exit strategy for all our positions right from the start… and makes sure we have the gumption to stick to it. This way, small losses don’t become catastrophic ones.
Knowing how much to invest in each and every situation is also crucial to building long-term wealth…
Our third pillar, position sizing ensures that even if a number of our investments turn sour, we’ll never lose our shirts again. As a guideline, we recommend investing no more than 4% of your equity portfolio in any particular stock. If you want to be conservative, invest less. If you want to be aggressive, invest more - but not too much more.
When used together, trailing stops and position sizing can limit the impact of any negative market move. For example: If you were to invest 4% of your portfolio’s value in any one stock, and you used a 25% trailing stop. A 25% drop in price would activate your trailing stop, and your total loss would amount to only 1%.
But if you’re looking for a refuge in these turbulent markets, take a look at our Perpetual Money Portfolio - which is yielding over 12.4% right now. It generates 100% to 200% more cash than standard “income investments” like money markets, bonds, or treasuries. And you avoid the excessive risk of so-called high-yield - but unsound - investments… Full story.
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