How to Become an Investor Series: Money Management 101

Once you've decided to embark on the challenging road to saving and investing, I recommend starting with some critically important first steps in money management. Obviously, step number one is developing the habit of saving…or hanging onto your spare cash. The next step in financial management is determining how much money to save before putting it at risk (i.e. investing it)…and where to store it.

Piggy Banks

Let’s assume you’ve started saving. What do you with the cash? In other words, how do you best manage your cash prior to the “risk-taking” investment phase?

The question is: What is the optimal location for storing this cash? In today’s world of readily available choices, anything is better than burying scarce dollars in a coffee can in the backyard or under your mattress. Much better choices exist.

A first consideration to ponder might be the accumulation of an emergency fund. This “rainy day fund” will provide you with a myriad of important “insurance” options. Among them the cash necessary to meet unforeseen emergencies without having to sabotage your investment goals. You might also set aside funds for a necessary down payment or large purchase. And you can stash the case in an account that earns interest.

At this beginning stage in your lifelong investor’s journey, it’s important to see cash for what it really is – a financial management tool – not an investment. Sure, cash can grow through compounding (more about that later), but let it serve as a safety valve to help protect your more risky portfolio ventures like stocks, bonds, or other assets.

Let’s consider some options. Banks and credit unions offer checking and personal savings accounts, money market accounts, and certificates of deposit insured by the Federal Deposit Insurance Corporation (FDIC). Mutual fund companies offer money market funds, often a good first investment for a new and/or inexperienced investor. Other options are out there but we’ll limit this discussion…and comparisons…to these more obvious choices for the moment.

Checking Accounts vs. Savings Accounts

Checking accounts are the most accessible and widely used accounts by younger gens. In fact, they're also popular with older folks, too. They are used primarily for paying bills, withdrawing cash (usually via debit or ATM cards) and for writing checks to cover on-the-spot purchases in lieu of cash. Although very convenient, banks typically offer little if any reward for holding your cash in a checking account. In short, they are very safe but not lucrative shelters for more than small sums of money.  

On the other hand, bank savings accounts are generally used to store more cash for longer periods, pay higher yields, and are useful in helping manage cash flow and shorter-term savings needs. Unlike checking accounts, they aren’t designed to handle a myriad of day-to-day transactions.

Money Market Accounts vs. Checking Accounts

Many banks offer money market accounts (MMAs) that, like savings accounts, are employed to keep depositors’ spare cash safe (and earning interest) for longer periods of time. And like savings accounts, MMAs can be used in conjunction with checking accounts to help manage short-term cash flow. MMAs have features similar to checking accounts but within certain limits.  MMAs aren’t used for daily transaction activities. But importantly, they offer different combinations of these desirable features:

• Higher interest rates than checking accounts

• FDIC coverage

• Check-writing and debit/ATM capabilities

Some less desirable features might include minimum balance and monthly withdrawal limits and maintenance or service fees. Of note, fees can often be avoided by maintaining a certain account balance or even by opting out of paper statements.

MMAs vs. Savings Accounts

For depositors who seek a higher interest rate but also want check-writing flexibility, MMAs typically offer a greater degree of accessibility than savings accounts. That checkbook and debit or ATM card allows the account holder to pay others or make direct withdrawals instead of transferring money to a checking account first. But remember, the frequency of withdrawals or transfers may be limited by bank rules, which might charge fees over those set limits. Of note, MMAs and bank savings accounts frequently offer similar yields, almost always substantially higher than checking accounts.

MMAs vs. Certificates of Deposit (CDs)

A certificate of deposit (CD) is a savings account that pays a fixed rate of interest on funds held for specific periods of time. They provide an option for savers who want to earn more than most savings, checking, or money market accounts without taking on more risk. 

They are protected by the FDIC within limits. Typically, CD rates are higher than MMAs and savings accounts (and the longer the term, the higher the rate), but the holder suffers a penalty upon early withdrawal, which reduces accessibility.

By contrast, MMAs allow withdrawals with relative frequency and without penalty. Available at banks, credit unions and brokerages, CDs are more conservative financial instruments than stocks and bonds but offer lower opportunity for growth. Folks often use them to save for specific mid-term purposes like a home down payment, a new car or a vacation. They can be used to hold emergency funds but are less accessible than MMAs and savings accounts because of the possibility of those dastardly early withdrawal penalties.

MMAs vs. Money Market Funds

A money market fund (MMF) is not the same thing as a money market account. Also called a money market mutual fund, an MMF is an “at risk” (though low) investment…a type of mutual fund that invests in highly liquid, near-term instruments such as cash, cash equivalent securities, and high credit-rated, debt-based securities with  short-term maturities (e.g., U.S. Treasury bills). MMFs offer investors high liquidity (e.g., great accessibility) with a very low level of risk. However, they are not FDIC-insured. Rather, they are insured by the Securities Investor Protection Corporation (SIPC). The limit of SIPC protection is $500,000, which includes a $250,000 limit for cash. SIPC works to restore to customers their securities and cash that are in their accounts when the brokerage firm liquidation begins. But it does not protect against the decline in the value of a customer’s securities. For this reason, it is important to recognize that SIPC protection is not the same as protection for cash at an FDIC-insured banking institution.

MMFs are very often used as a clearing account – a place to park money temporarily after selling an investment or before making an investment requiring a cash outlay. Money market mutual funds usually come with very reasonable fees and expense ratios. Barring a general market catastrophe, fund companies hold MMFs at a $1 value per unit despite market fluctuations in the fund’s valuation.

MMF shareholders can typically write checks on their account and withdraw money at any time, but they often have a limit on the minimum dollar amount of a withdrawal and the number of times withdrawals can be made during a certain timeframe. An MMF covered by the SIPC is not as safe as an MMA covered by the FDIC (which insures bank MMAs, savings and checking accounts and CDs up to $250,000 per account holder, per ownership category, per bank). The SIPC protects against the loss of cash and securities held by a customer at a SIPC-member brokerage firm, and the FDIC provides eligible coverage if the bank fails.

I prefer MMFs because they often offer higher yields than bank options and low-risk, highly liquid SIPC-insured service. On the other hand, as an investment vehicle, they offer no capital appreciation, are subject to interest rate fluctuations and monetary policy, and are not FDIC-insured.

Account Caveats

Withdrawal Limits:

Banks have withdrawal limits on savings accounts and can impose penalties when exceeded, which they must disclose. By law, they can’t impose a monthly withdrawal limit of less than six on savings or money market accounts. Money market funds can and often do impose similar limits. Banks have the discretion to decide how much money one must keep in an account to avoid fees or account closure. However, be aware that some banks might require no minimum balance but only pay interest once an account hits a certain dollar amount.

Annual percentage yield (APY):

This is the rate of return on an account balance, including compounding, over a year. Banks can chose to compound daily or monthly and the account balance will likely fluctuate as deposits and/or withdrawals are made. So the actual amount of interest earned won't likely match the advertised APY.

In Sum

Money management is the key to optimizing portfolio investment yields. Stay on top of your cash particularly in the beginning as you head toward investing. The little things do matter, so watch your pennies…and the dollars will take care of themselves.

Source Information:

¹The Net Asset Value (NAV) Standard: all the features of a standard mutual fund apply to a money market fund, with one key difference. An MMF aims to maintain a net asset value (NAV) of $1 per share.  Any excess earnings generated through interest on the portfolio holdings are distributed to the investors as dividend payments. One of the primary reasons for the popularity of money market funds is their maintenance of the $1 NAV. This requirement forces the fund managers to make regular payments to investors, providing a regular flow of income for them.