The Money Market As A Tool For The Risk-Averse Investor
Eunice gets a proposal to invest a sum of one million Naira in an investment scheme with the potential to earn some millions in return. However, upon review, Eunice realizes that even though the investment could yield her much more on the upside, it could also cause her to lose her entire savings. Eunice decides against making the investment in the business deal due to the risk it poses to her capital.
Making money is, no doubt, a daunting task. It requires learning, unlearning, hard work, and more. For some people, the allure of making more money is exciting enough to take the risk. However, for the risk-averse investors like Eunice, capital preservation is a much better deal.
A risk-averse investor is one who will opt for lower returns with known risks as opposed to higher returns with unknown risks. In other words, among various investments offering the same rate of return and different levels of risks, this investor always prefers the alternative with the least risk.
A risk-averse investor avoids risks. He or she stays away from high-risk investments and prefers investments that provide a sure return. The person will pass up the opportunity for a large gain in favor of safety. So, they prefer investing in an evil they are familiar with, rather than opting for a strange one.
Attributes of Risk-Averse Investors
- They are conservative investors
- They prefer the safety of principal over potentially higher income.
- Risk-averse investors are all about liquid investments. That is, they prefer situations whereby if there is a need to put a stop to a particular investment, they can get back their money with a short period.
- Risk-averse investors generally favor dividend growth stocks, government and corporate bonds, fixed deposits, money market funds, and savings accounts
The idea is to avoid relatively higher risk investments such as stocks, options, and futures and focus on investments with guaranteed returns and lower-to-no risk.
The Money Market
The money market is home to short-term debt investments. It gives the investor an opportunity to invest in highly liquid vehicles like call deposits, high-rated debt securities like treasury bills, commercial papers, bankers’ acceptance and so much more.
At the wholesale level, it involves large-volume trades between institutions and traders. At the retail level, it includes money market mutual funds bought by individual investors and savings and certificate of deposit accounts opened by bank customers.’
Basically, the money market involves a form of trading by participants which involves borrowing and lending money within a short-term period.
Investors with excess capital with no business to undertake can invest in the market and earn interest.
Some of the instruments traded in this market include treasury bills, certificates of deposit, commercial paper, federal funds, bills of exchange, and short-term mortgage-backed securities and asset-backed securities.
Money Market Instruments To Invest In
For the risk-averse investor, one of the easiest things to invest in is a commercial paper. A commercial paper is a short term debt instrument. It is an unsecured loan that is issued out by a corporation for it to meet its short term needs and to finance accounts payables. These corporations are, as expected, highly rated companies.
The way it works is that large companies that are financially stable and have attained some measure of growth and recognition can easily raise the much-needed funds for their business through short term unsecured promissory notes.
Upon issuance, they do not last longer than 270 days. Backed by the company’s assets, they are issued at a discount to the face value of the asset it is backed against. They are issued at the prevailing rate of interest at the time of issuance. CPs are backed against current assets like accounts payable and inventories, and not fixed or non-current assets.
Probably one of the most common money market instruments in Nigeria, treasury bills offers a government of any nation to the avenue to raise money from regular individuals or corporations.
In Nigeria, they are issued by the Central Bank of Nigeria (CBN) on behalf of the government to finance government expenditure. They exist in three standard investment tenors, spanning a period of either 91 days, 182 days, or 364 days.
In other words, they are securities that mature in a year or less. They are also sold at a discount and redeemed at par so when an investor cancels before maturity, he or she loses an amount of money. As a result of their nature, they are highly liquid; that is, they can easily be exchanged for cash with other investors.
Another peculiarity of treasury bills is that interest accruing are paid upfront and credited to your bank account upon purchase.
Certificates of Deposit
A certificate of deposit or CD as it is popularly called refers to a proof of deposit with a bank that is repayable at a predetermined period. It is a certificate or a document by which a bank raises funds from the secondary money market.
CDs are also short-term securities having a fixed interest rate and a fixed date of maturity. With a CD, the holder of the certificate can sell it in the secondary market as he or she deems fit. Like other money market instruments listed, they also usually are up to 12 months.
With short term CDs, there are no coupons; rather, the holder receives the principal and accrued interest at the time of maturity.
A repurchase agreement, also known as a repo, is another money market instrument that is used to raise funds in the short term.
The way it works is that a bank can choose to raise short-term funds by selling some of its securities but promising to repurchase them in another short period of time. Consequently, the person originally buying the security with the objective of selling in the future, the transaction is known as a reverse repurchase agreement or reverse repo.
Used mainly in government securities, the underlying security is sold to investors and purchased back shortly afterward at a slightly higher price. Sometimes, this is as short as the very next day.
The buyer of the security or the lender then executes a reverse repo to close the investment process and this is what is known as a reverse repo. The repurchase agreement and the reverse repo agreement are majorly used by large financial institutions to raise money.
For the individual that is selling the security and also repurchasing it in the future, the transaction is a repurchase agreement (RP).
A Bankers Acceptance is something of a letter of credit or a postdated cheque. It is also a short-term credit instrument and it is made by a bank on behalf of a business and serves as a promised future payment by a financial institution.
The idea is that the payment is guaranteed by the bank where it guarantees that one of its customers will pay for goods received in a period that spans a month or two. It usually does not exceed 60 days (two months).
These money market instruments and more are great in that they generally offer and pay higher interest rates than regular savings bank accounts and also help you protect your principal.
A more sustainable way to invest in the money market is to have a portfolio of money market investments and this comes with investment in a money market fund.
Investing In A Money Market Fund
A money market fund is simply a portfolio of money market investment instruments. Money market funds are open-ended mutual funds that are highly liquid and are suited to investors seeking the preservation of their capital.
The average maturity of all the instruments in their portfolio, knowns as the Weighted Average Maturity (WAM) is usually under 90 days. As opposed to investors investing in individual securities they pool their monies together with other investors and invest in a basket of money market securities.
Some of the great benefits of money market funds are diversification. When rates in the money markets are trending downwards – an example is the recent crash of treasury bills rates in Nigeria.
Since money market funds invest in a mix of money market securities of various tenors’, investors feel the impact of falling rates much less than if they invested individually in each of the securities.
Money market funds most times offer higher interest rates than the average savings deposit rate despite the minimum investment sum required to invest.
With investors pooling their funds together they get the benefits of economies of scale which gives room to negotiate higher rates and participate in markets only open to large institutional investors,
Another benefit a money market fund offers is professional money management. The funds are managed by professionals who are focused on the objective of maintaining asset value stability while also optimizing returns.
Asset allocation for this could be spread across bank placements, short term government securities, money market securities, and cash and cash equivalents.
While there are costs associated with money market funds much like any other mutual fund, they are typically low.
Signing up for a good money market fund saves you the time and stress of tracking treasury bills maturing, auction dates, instruments to invest and negotiating interest rates in order to preserve your capital and earning good returns