Is there any drawback in putting all my 401K into a money market fund?

Question

As you may know, the stock market drops like crazy, I did sense that a couple weeks ago and transferred some of my fund to money market - well, at least to keep it as dollar value...

However, I am wondering what would be the drawback to do that?

Answer 1

What you're describing is called timing the market. That is, if you correctly predict when the market will drop, you can sell before the drop, wait for the drop, then buy after the drop has occurred. Sell high, buy low.

The fundamental problem with that, though, is:

1. You rely on your ability to predict both the timing of the drop (and the drop itself), and the timing of the rebound (and the rebound itself).
2. Since the stock market is priced based on what everyone else thinks is going to happen, you're comparing your ability to predict drops and timing to everyone else - including people who have very complex computer models, and who do it for a living.
3. There are transactional costs (ie, commissions).
4. The stock market is not a zero sum game; over time, assuming the economy is still reasonably healthy (which it currently is), it will gain due to the production/profitability of the companies themselves.

What ends up happening, on average, is you end up slightly behind. There's quite a lot of literature on this; see Betterment's explanation for example. Forbes (click through ad first) also has a detailed piece on the matter.

Now, we're not really talking HFT issues here; and there are some structural things that some argue you can take advantage of (restrictions on some organizational investors, for example, similar to a blackjack dealer who has to hit on 16). However, everyone else knows about these too - so it's hard to gain much of an edge.

Plenty of people say they can time the market right, and even yourself perhaps you timed a particular drop accurately. This tends to lead to false confidence though; how many drops that you timed badly do you remember?

Ultimately, most investors end up slightly down when they attempt to time the market, because of the transaction costs (if you guess two drops, one 'right' and one 'wrong', and they have exactly opposite gains/losses before commissions, you will lose a bit on each due to commission), and because of the overall upward trend in the market (ie, if you picked at random one month a year to be out of the market, you'd lose around 10% annualized gains from doing that; same applies here).

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All of that aside, there is one major caveat: risk tolerance. If you are highly risk tolerant, say a 30 year old investing your 401(k), then you should stay in no matter what. If you're not - say you're 58 and retiring in a few years - then knowledge that there's a higher risk time period coming up might suggest moving to a less risky portfolio, even at the known cost of some gains.

Answer 2

The drawback is not knowing when prices have reached a level where you are comfortable getting back in.

Someone who got out at S&P 1500 before the crash of '08 was very happy. But did they get back in at 666 or just watch the market come back 3X from that level? The S&P returned 10.46% from Jan '87 till Dec '14. I wonder how many traders got in and out just right to beat that number?

Bottom line is that even the pro's acknowledge that timing the market is basically impossible, so why try?

Answer 3

(After seeing your most recent comment on the original question, it looks like others have answered the question you intended, and described the extreme difficulty of getting the timing right the way you're trying to. Since I've already typed it up, what follows answers what I originally thought your question was, which was asking if there were drawbacks to investing entirely in money market funds to avoid stock volatility altogether.)

Money market funds have the significant drawback that they offer low returns. One of the fundamental principles in finance is that there is a trade-off between low risk and high returns. While money market funds are extremely stable, their returns are paltry; under current market conditions, you can consider them roughly equivalent to cash. On the other hand, though investing in stocks puts your money on a roller coaster, returns will be, on average, substantially higher.

Since people often invest in order to achieve personal financial stability, many feel naturally attracted to very stable investments like money market funds. However, this tendency can be a big mistake. The higher returns of the stock market don't merely serve to stoke an investor's greed, they are necessary for achieving most people's financial goals. For example, consider two hypothetical investors, saving for retirement over the course of a 40-year career. The first investor, apprehensive Adam, invests $10k per year in a money market fund. The second investor, brave Barbara, invests $10k per year in an S&P 500 index fund (reinvesting dividends).

Let's be generous and say that Adam's money market fund keeps pace with inflation (in reality, they typically don't even do that). At the end of 40 years, in today's money, Adam will have $10,000*40 = $400,000, not nearly enough to retire comfortably on. On the other hand, let's assume that Barbara gets returns of 7% per year after inflation, which is typical (though not guaranteed). Barbara will then have, using the formula for the future value of an annuity, $10,000 * [(1.07)^40 - 1] / 0.07, or about $2,000,000, which is much more comfortable. While Adam's strategy produces nearly guaranteed results, those results are actually guaranteed failure. Barbara's strategy is not a guarantee, but it has a good chance of producing a comfortable retirement. Even if her timing isn't great, over these time scales, the chances that she will have more money than Adam in the end are very high. (I won't produce a technical analysis of this claim, as it's a bit complicated. Do more research if you're interested.)

Answer 4

Yes. There are huge disadvantages to saving money in a money market account.

1. Money market accounts earn less than inflation. So your money loses value.
2. When the fund price drops, buy more shares, then when it comes back you profit more. (Buy low).
3. While your money is in money market, you do not gain any dividends.
4. When the market recovers, if it makes a quick jump and then you buy in on the way up, you're buying high.
5. When the market drops quickly then you sell during the drop, you're selling low.

Money market account can be a good place to save some of your emergency fund, because it's basically a cash account and you can withdraw from it at will, with few delays. It's liquid.