Finally you have a little extra money to invest for a big purchase later, such as a house or car, or to put into your retirement savings. But acquiring the money — no matter how difficult — is the easy part. Deciding how to best invest it is the hard part. Sifting through numerous investment options and hyperbole spouted by investment brokers can leave you confused, overwhelmed and reluctant to do anything at all. The big question you face is whether to keep your money ultra safe in a money market mutual fund or take a chance for greater return on your investment in the stock market.
The money market has nothing to do with currency trading. It is actually the short-term end of the bond market, and money market investments are essentially short-term loans to banks and corporations that pay interest and return principal at maturity. Certificates of deposit, banker's acceptances (international trade finance), commercial paper, repurchase agreements and U.S. Treasury bills make up what is known as the money market. Investment terms are generally less than one year, though they can be as long as two years until maturity. You can purchase mutual funds that invest in money market instruments. These mutual funds are often known as cash management accounts. Money market investments are traded via phone and computer (over-the-counter) directly between banks and brokerage firms.
Common stock represents a fraction of a percent ownership in the underlying company. It continues to exist until the company either goes out of business or merges with another company. Stock has no maturity date. Some stock pays dividends on a quarterly basis. An investment in stock may appreciate in value, but it may also decline in value, causing you to lose money. When you want your money back, you sell your stock holding. Stocks may be traded on a stock exchange or over-the-counter (OTC) via the Nasdaq, which is a computer trading platform that links traders at all brokerage houses.
Money market instruments are appropriate investments if you want safety of principal plus a little income. Stocks are appropriate if you want to trade them for profit or hold them long-term in anticipation of dividends and potential price appreciation. Again, price appreciation is not guaranteed, and you may actually lose money on a stock investment.
There are tax differences to be considered when deciding whether to invest in money market instruments or stock. Interest on money market investments is taxed as ordinary income. Long-term capital gains, or profit from a holding of stock for more than a year, is taxed at a lower rate than short-term capital gains, or profit from trading stock holdings of less than one year. Dividend income is also taxed at a lower rate than ordinary income.