Breaking The Buck Is Not a Big Deal

If you have read newspaper or watched TV, you probably heard that a big money market fund “broke the buck” last week. That means it was not able to maintain the stable $1 Net Asset Value (NAV). Investors in that fund lost 3% when the NAV dropped to $0.97. Another money market fund run by Putnam decided to shutdown and return the money to the investors because it didn’t want to sell its assets in a difficult market. Later the federal government said they would guarantee the money market funds.

As the title of this post reads, I say breaking the buck isn’t a big deal. Why? Because it happens all the time. You just don’t know it because it isn’t obvious. This is called money illusion. The before-tax, before-inflation value isn’t that meaningful. You can’t spend before-tax, before-inflation money. You can only spend after-tax, after-inflation money. When you factor in tax and inflation, money market funds lose money all the time.

Here are the returns of Vanguard Prime Money Market Fund, one of the best money market funds in the U.S. At a marginal tax rate of only 15%, the fund’s after-tax, after-inflation return was negative four years in a row from 2002 to 2005. It’s also negative so far in 2008. If the tax rate is higher, it gets worse. If you are interested in seeing the numbers for a different tax rate, you can use the online spreadsheet I created.

So if you are already losing money in a money market fund, what’s the big deal of losing a little bit more?

Looking at a different angle, even if a money market fund breaks the buck before tax before inflation, you will see that the fund actually performed a lot better this year than other mutual funds. Again, using Vanguard data through Sept. 19, 2008, including the big rebound on Sept. 18 and Sept. 19, the 2008 year-to-date returns are:

Vanguard Prime Money Market Fund +2.05%
Vanguard Total Bond Market Index Fund +1.42%
Vanguard 500 Index Fund -13.23%
Vanguard Total Stock Market Index Fund -11.82%
Vanguard Total International Stock Index Fund -23.03%
Vanguard Emerging Markets Stock Index Fund -29.86%

My thoughts on the risks in money market funds didn’t change from what I wrote last year. Worrying about a money market fund losing 1%, 2% or 3% while other funds have lost 15%, 20%, or 30% is really focusing on the wrong problem.

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Comments

  1. Paul says

    Technically you are correct. However two things occur to me. 1. I have never seen anyone apply the money illusion in a general audience investing article until now. People probably do generally understand this fact but investment returns are not stated in this context. Most general investors likely consider ALL personal investment returns as “gross” not including the illusion. (Maybe the individual’s tax situation is the factor that tends to most influence this view.) There is personal consistency in the way the individual views his/her returns. The technical consistency of the illusion should exist too but is most often overlooked. 2. Money market funds have a reputation and CONFIDENCE level associated with the fact that the NAV will almost never vary from $1/share. People’s expectations especially after years of a consistent NAV are that it takes a major crisis to cause a variation in money market NAVs. Now we are seeing a couple of funds have this issue. Confidence is shaken and it is a big deal. Certainly a few percent compared to current equity fund ytd losses is minimal. Yet it is substantial based upon the history of MMFs through ~30 years of good and bad ecomonic times.

  2. Dave says

    An additional point is that these losses are occurring in a year where inflation is running at 4-5%! So the real losses are in the 7-8% range. I would be upset with 7-8% losses in a balanced fund, let alone a money market account. So I agree that it is a big deal.

  3. simplesimon says

    I think this is a very interesting perspective about nominal vs real dollars. What you’re arguing is that being in cash will lose to inflation. This is Investing 101. Anywhere you read will say to invest in the stock market for the long term to beat inflation and have enough money for a comfortable retirement.

    But most people (I think) invest in money market funds for purposes like house down payment savings, car savings, emergency funds, or whatever else that will require liquidity and retention of principal. And like Paul said above, the psychological effect of seeing something believed to be unwavering through market conditions break the buck is, imo, pretty scary.

    I kinda agree that it’s not a big deal though, but I don’t see it the way that you presented because I know cash loses to inflation in the long run. It’s not the reason I have a cash account.

  4. TFB says

    It’s not even about the long run. If money market funds are yielding 2% while inflation runs at 6%, I guarantee you there won’t be a headline about breaking the buck. People are OK with it. If the money funds broke the buck to -1% while inflation runs at 3%, all hell breaks loose. That doesn’t make much sense but I understand why people feel differently one way versus the other. Money illusion is well documented.

    Losing money is never pleasant, whether nominal or real. But losing money in a money market fund is still the least of my worries. If there is a time machine, I’d be SO HAPPY to trade my losses in other funds for some crappy money market funds that broke the buck.

  5. Chris says

    It is all about perception. People expect a money market to not have losses. People expect a 10% annual return on their 401k once they retire. This is a huge ponzi scheme. The demand for stocks will weaken. Losses will increase.

  6. Jeff says

    Although inflation is 6%, won’t interest rates eventually pick up? I mean, since inflation is raising the costs of everything, eventually investors will want a real return. Or will the Fed keep their target interest rate low, thereby preventing the credit market to function normally. But, then again, the credit market isn’t quite normal and hasn’t been since the 1990′s.

  7. Bruce says

    The thing about breaking the buck is that you lost 3 % in one day. That is a huge annualized loss on what was supposed to be risk-free.

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