There are two ways to manage wealth: maintaining what you have or growing it.
Which path to choose can be confusing. And recently, investors are jittery due to reports of rising inflation.
Where to invest your money boils down to two components of the financial market: the money market or the capital market.
The money market and the capital market are two large components of the global financial market where the funds invested are used for short-term or long-term borrowing and lending.
Here are the key differences between them and advice to help you navigate where to invest.
Money Market Overview
“The term ‘money market’ is applied to high quality, short-term debt instruments that mature within one year,” says Robert Johnson, professor of finance at Heider College of Business, Creighton University, and the co-author of “Investment Banking for Dummies.” They are known to have a low return but are considered safe.
If you need money within one year for a planned expense, such as a down payment on a house, keep it in the money market.
These debt instruments include:
- U.S. Treasury Bills, sometimes called T-Bills, is a short-term debt issued by the U.S. Treasury. The public can purchase a T-Bill and essentially act as a lender to the U.S. Government. The Treasury will pay back the purchaser on a specified maturation date with interest.
- Certificates of Deposit, offered by banks and brokerage firms where you can deposit funds for a period of time to accrue interest.
- Commercial Paper, which is basically a corporate IOU. The company issues a note unbacked by collateral, which they promise to repay at the maturation date with interest.
Capital Market Overview
The capital market is a way to accrue value over time with longer-term assets with maturation periods beyond one year. This includes stocks and bonds.
Key Differences: Money Market Vs. Capital Market
The money market and capital market operate differently and tend to appeal to different types of investors.
The risk-averse investor worries about losing money. This investor will feel more comfortable using the money market because they will preserve the money they have, even if they will only generate a modest return on their investment.
The short-term investor needs money in the near term – within a year. While this is often spoken about in terms of proximity to retirement age, there are other reasons you might need money soon, says Riley Adams, CPA, senior financial analyst for Google, and owner of personal finance blog the Young and the Invested. Perhaps you’re saving up for a new car, house, or college. Whenever you need the money soon, your number-one priority is preserving it – preferring the security of the money market.
The risk-tolerant investor understands that risk is the price you pay for the potential of a big reward and seeks the potential for greater profit offered by the capital market.
The long-term investor has a long time horizon, so they can invest in the capital market. If stocks fall, these long-term investors will generally be able to recoup losses over time.
Comparing Money Market and Capital Market
From the investor point of view, “the primary difference is the money market is short term, very safe, and very liquid,” says Adams. Comparing the money market and the capital market point by point can help you understand why the money market can be the preferred choice for a short-term investment need and how it differs from a capital market investment like buying stocks.
This chart can help you conceptualize the formats, pros, and cons of these two financial markets.
|Comparison Point||Money Market||Capital Market|
|Examples||Certificates of Deposit (CD), Treasury Bills, Commercial Paper||Stock shares and Bonds|
|Duration||Short term (1 year or less)||Long term (greater than 1 year)|
|Investment objective||Maintain wealth||Generate wealth|
|Level of risk||Low||High|
|Level of volatility||Low||High|
Which is a Better Investment?
The best place to invest “depends on your goal and your time horizon,” says Johnson. For investors with a long time horizon, such as a twenty-something saving for retirement, the capital market is the better pick. A large-cap index fund is a good start for these investors, recommends Johnson.
“If you need that money within a year or two, it’s best to just put it in the money market because of that volatility,” Johnson recommends. The money market is a lower risk. “People who invest in the money market can sleep well. There’s very little volatility but very little growth,” says Johnson.
Those that need the money soon will be motivated to preserve wealth rather than accumulating it. You wouldn’t put money you were saving for a down payment in the stock market (capital market) because there’s a chance it could fall into correction, and you’d no longer be able to afford your dream house. With a money market investment, your down payment wouldn’t grow very much – but it wouldn’t evaporate due to market volatility, so you can rely on it to be there when you get ready to make that offer.
Conversely, “those capital market investors may suffer some sleepless nights when the market falls into a correction,” says Johnson. Despite the risk, though, those who invest in the capital market can be rewarded better than the money market if they wait it out.
“If you’re looking for long-term, like retirement, you want that to be in a capital investment,” Adams explains. However, the time will come when you need to transition that money from capital market investments to money market investments. “As you near any major purchase decision where you need the money you have, you want to plan a transition from the capital market to the money market because that guarantees your money will be there,” Adams says.
Since 1926, the S&P 500 – a capital market – has increased by 10.3% annually, Johnson says. Hiding within the average is the statistical fact that there are good years and bad years. Investors with long time horizons can generally take advantage of those banner years where stocks grow greater than 10% to offset the years its drops below that.