In the lesson on bonds, you were introduced to capital markets: exchanges where long-term loans are traded. There are also markets for short-term loans: the money market. And you can invest in those too, for example through a money market fund.

What is a money market fund?

A money market fund pools money from many investors and puts it into short-term loans. The fund earns interest on those loans, which is distributed among investors in proportion to their stake.

The risks of money market funds

If you paid attention in the bonds lesson, you'll already be familiar with the risks of investing in loans. Borrowers can go bankrupt, which means you could lose your investment. And if the prevailing market interest rate rises above the rate on your loan, the value of that loan falls.

With short-term loans, those risks are generally smaller. A company is more likely to run into trouble over ten years than over one year or a single night. The chance of interest rates changing significantly in the short term is also lower. You could say that, in general, with short-term loans, there's simply less time for things to go wrong.

That said, investing in short-term loans is not risk-free. The same risks apply as with bonds: the short duration simply means those risks are considered less likely to materialise.

An alternative to saving?

Because of its relatively low risk profile, investing in a money market fund is sometimes seen as an alternative to a savings account, one that can offer slightly better returns. Even so, it's important to understand the differences clearly.

As an investor, you always carry the risk of losing some or all of your money, even when that risk is considered low. Investing also involves different costs than saving. And crucially, you cannot rely on deposit protection if the fund or your investment platform goes under. Deposit protection schemes, such as the Dutch deposit guarantee scheme, which protects up to €100,000 per person at a Dutch bank, only cover savers, not investors. As an investor, you fall outside that safety net.

Protected by collateral 

While investors can't access deposit protection, money market funds often provide other forms of security. One common approach is requiring borrowers to provide collateral.

Collateral works in much the same way as a mortgage agreement, wherein your home acts as collateral. If you run into serious financial difficulty and can no longer repay the mortgage, the bank can sell your home and use the proceeds to recover the outstanding amount.

Key takeaways

• Investing in a money market fund means investing in short-term loans.
• The risk of money market fund investing is generally considered relatively low.
• Money market funds are sometimes seen as an alternative to saving, but the risks, costs and protections differ.
• To lower risk exposure for investors, money market funds often require borrowers to provide collateral.