The stock market can be pretty volatile, and stock prices go up and down depending on market movements. But does this have anything to do with mutual funds? And if you have invested in mutual funds, might the stock market have any impact on your investment?
Mutual funds are affected by the stock market since they invest their money primarily in various equities. When stocks rise or fall in value, the equities held in the mutual funds’ portfolio behave likewise. However, if you invest for the long term, such fluctuations won’t affect your investments.
In this article, you will find more detailed information on how the stock market affects mutual funds. You will also learn the following:
- The relationship between mutual funds and the stock market.
- How mutual funds protect themselves from volatile market conditions.
- How you can protect your investment from stock market changes.
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Table of Contents
What Is the Relationship Between Mutual Funds and the Stock Market?
The stock market is where trading company shares takes place, while mutual funds are schemes that pool together investors’ funds and then invest in these stocks.
Both industries affect each other in such a way that performance in one affects the other.
Mutual fund investments are highly susceptible to market risks in such a way that stock price movements affect the value of the funds invested in various equities. On their part, mutual funds also impact stock prices and thus the stock market because of their sheer size.
How Does the Stock Market Affect Mutual Funds?
The stock market can affect a mutual fund in any of the following ways:
- The value of the securities held by the fund can decline. Mutual fund investments depend on the performance of the stock market, which means market movements have an impact on the fund’s portfolio. These movements could be positive or negative. So if share prices were to go down, you could either lose some of your money or the entire investment.
- Changes in market conditions could lead to the non-payment of dividends or interest. This means that affected companies would not declare any dividends, which means that investors would not receive the regular dividend payouts for a given period.
- Panic withdrawals from the fund are influenced by market volatility. In most cases, investors panic when the stock market experiences severe fluctuations and resort to panic selling of shares and withdrawing funds from the mutual fund over fears that its value might slide much further down. When too many investors sell off their units, the fund’s Net Asset Value goes down both as a result of the withdrawals and price swings.
How Mutual Funds React to Stock Market Changes?
It’s important to bear in mind that there are various types of mutual funds, and they all react differently to market changes or corrections, as shown below:
Equity Mutual Funds
These are the most volatile types of mutual funds and have the potential to deliver the highest returns. The stock market affects Equity funds’ returns significantly since they invest mainly in shares.
Debt Mutual Funds
Debt mutual funds invest the most significant percentage of their portfolio in debt instruments such as corporate and government bonds and usually have fixed interest rates.
While share market price swings don’t affect debt funds as much, their interest rates could also fluctuate because of market movements. And this would, in turn, affect the value of the related mutual funds.
Liquid Mutual Funds
Liquid mutual funds are debt funds that invest in securities with extremely short maturity tenure. And since the instruments have a fixed rate of return, they remain secure, and stock price volatility does not affect them.
That said, if the liquid fund’s portfolio contains any equities, market fluctuation would have a marginal impact on the fund’s performance.
How To Protect Your Mutual Fund Investment From Stock Market Changes?
The stock market is unpredictable, and it is not always possible to time the market, even for seasoned investors. Fortunately, there are a number of strategies you can use to protect your mutual fund investment from the adverse effects of stock market changes. Some of them include:
Making Regular Investments
Making consistent investments can help you ride stock market fluctuations.
Rather than trying to time the market, keep making regular deposits into your mutual fund account and buying more fund units. Furthermore, if you are following the Systematic Investment Plan (SIP) mode of investing, continue doing so irrespective of the prevailing market fluctuations.
This system works on the principle of dollar-cost averaging, where you purchase a fixed number of unit funds each time.
Thus, you end up with few units when prices rise and more when prices go down. Eventually, you’ll find that in the long term, short-term fluctuations will merely have a minimal effect on your investments.
Diversifying Your Portfolio
Mutual funds typically diversify their investment portfolio, which means that even if the stock market crashes, you may not necessarily face huge losses as a result of falling share prices.
The thing is, while mutual funds invest in the shares traded at the stock exchange, they spread their risk by investing in different sectors.
Diversification cushions the fund’s portfolio in the event of adverse market conditions such that a drop in value in one or more sectors doesn’t affect the entire portfolio.
Choosing the Most Suitable Type of Mutual Fund
It’s essential to choose the right type of mutual fund for you.
To do this, determine your risk profile, as this is what will guide you in selecting the most appropriate investment. For instance, index funds allow you to put your money in a passive but less risky investment whose returns are consistent with a market index.
Next, be wise when selecting your potential mutual fund.
The funds that eventually outperform the market are those led by a skilled management team. That is why some schemes can deliver returns at 15% while others only manage 8 to 9%. While there are no guarantees, a fund manager’s experience and tracking the fund’s past performance might give you an idea of what to expect in the future.
Finally, fund managers take great care when making their stock selection and are skilled enough to pick the right time to exit from non-performing stocks.
The mutual funds themselves also have in place risk management strategies to protect their investors’ capital if the market starts to move unfavorably. While their actions might affect the fund’s Net Asset Value, it will return to its initial position once the market finally settles.
Having an Investment Goal
When investing, it’s crucial to have a goal, which guides you in deciding on the type of investment to pick, the investment amount, and how long to invest. Therefore, if your mutual fund investment aligns with your goals, you should focus on these and not let market fluctuations sway you.
One thing to remember is that when the markets are volatile, you only lose on paper, which means that unless you sell off your units, there is no loss. Besides, riding out market cycles helps you take advantage of the power of compounding and reap higher returns in the long run.
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Conclusion
Mutual funds invest in the stock market. Therefore, their values depend on the stocks they hold in their portfolio.
Fortunately, there are steps you can take to protect your investment from stock market changes. These include choosing the right fund, being disciplined about making regular investments into your mutual fund, and having a long-term investment horizon.
The above actions are vital in mitigating market fluctuations. So, while the stock movements might affect your investment in the short run, you will still realize considerable returns if you stick it out for the long term.
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