There are four reasons to hold money market instruments in an investment portfolio:
- a temporary home for idle cash balances
- maximising total investment returns
- diversification benefits
- active trading opportunities
Before looking at these reasons, it should also be noted that for most investors exposure to money markets can only be achieved through investment funds. Money markets are primarily professional, wholesale markets in which direct investment is prohibitively expensive.
A temporary home for idle cash balances
Income not required for spending can be held in money markets rather than a retail bank deposit. The return will be higher, but can only be achieved with relatively large size investments.
There are times when money markets yield more than bonds or equities. It is usually most profitable to switch out of capital markets and into money markets (or temporarily avoid making longer term investments) when times have been good, but prospects are worsening and inflation is set to rise - at the peak of a market cycle. Money market investments can then gain value because their low credit risk becomes more highly valued; and because their rates of return are set for such short periods, they do not expose an investor to any appreciable investment, market or inflation risk.
As point 2 indicates, bond and share prices tend to move together and they both move in an opposite direction to money market instruments. As money market returns are usually negatively correlated with capital market returns, they offer the strongest possible diversification benefits to smooth out the volatility of returns on a portfolio.
The short term nature of the investments helps to make them safe - but it doesn't make them any more stable in terms of investment returns. Short term interest rates, by definition, fluctuate frequently. So for most of the time, the asset class is the lowest yielding - but it is still price volatile.
This unique combination of price volatility and safety (in terms of default risk) creates another reason to hold money market instruments - their trading potential.
This safest, most volatile and liquid asset market provides more profitable trading opportunities than any other class - but usually not for private investors. To get standard dealing rates you need to trade in large size (e.g. USD 5m minimum) and there is no strategic point in wanting to trade less because profitable opportunities are only created by very small price differences - so a lot of money needs to be put on any one trade.
It is a highly sophisticated, professional market, with cashflows closely associated with the foreign exchange and repo markets; and involving a lot of associated derivatives trading. You need to be highly trained and backed-up by a vast amount of data and analysis to identify profitable opportunities.
Realistically, it is an exclusive game for the Treasury departments of governments, international banks and multinational companies. So most private investors (even the 'wealthy' in private terms) can only benefit from the profit potential of active money market trading by pooling their cash into a managed fund. Cash needs to be available for at least a year to have a high probability of earning a higher return than in other asset classes.
Longer term debt securities -bonds - are far more accessible to the private individual.