Don’t let financial jargon scare you from investing in mutual funds! Here’s why
What do you hear in every mutual fund advertisement? “Mutual funds are subject to market risk. Please read the offer document carefully before investing.” This statutory warning cautions investors about market risks that could affect their investments.
But how do these market risks affect your mutual fund investments?
When you invest in mutual funds, you indirectly invest in different asset classes. You invest in stocks, bonds, and other fixed income securities. The value of your mutual fund investment is known as its net asset value (NAV).
Any asset class, be it stocks or bonds, faces market risk. However, this risk is a product of volatility. Stock markets are comparatively more volatile than bond markets. Therefore, stock markets are riskier than bond markets.
What is mark-to-market?
The value of your mutual fund scheme changes every day. This change in the value of assets is called mark-to-market. It represents market volatility and is present in both the stock market and the bond market. This is precisely the risk that the mutual fund disclaimer addresses.
Why do stock prices fluctuate?
A large number of buyers and sellers determine stock prices in the stock market. Stocks are regularly bought and sold in stock exchanges. This buying and selling can lead to price fluctuations.
Stock markets are based on market sentiments. These market sentiments are nothing but the investor’s emotions. They are influenced by events such as inflation, elections, natural disasters, agricultural and industrial productivity, etc.
For example, let’s assume the upcoming Lok Sabha elections will result in a coalition government. Given the political scenario, investors are likely to consider future economic and political uncertainties. This could hurt the investors’ confidence in the economy and subsequently cause the market to drop.
Now let’s suppose you invested in an equity-based mutual fund. The NAV of your fund might fall for a short period. However, at times like these, you can benefit from staying calm. Indulging in panic sales could lead to losses. You may want to start a new SIP instead.
When markets slip to new lows, you can take advantage by investing in quality stocks through mutual funds, thus benefitting from the ‘buy low’ approach.
Investing in equity-based mutual funds can yield a profit if you think long-term. Over the short term, equities display volatility. However, in the long run, they (via mutual funds) offer returns over and above inflation. So market losses may not affect a long-term mutual fund investor.
Why do bond prices fluctuate?
A bond is just like a loan, which a company takes for a pre-determined business motive. Thus it has a regular predetermined interest payout and a fixed maturity period. The interest rate for a bond is known as a coupon.
Bond markets witness lower risk and volatility. However, you face the chance of getting a lower interest rate for your investment in the bond market.
As an investor, which bond will you choose? If investors prefer bond ‘B’ over bond ‘A’, the earnings of the latter will fall, leading to a fall in the market price of bond ‘A’. Therefore, new investors will be able to invest in bond ‘A’ for a lower price.
In this case, the investors of bond ‘A’ can benefit if they invest for short-term goals. The tenure of your short-term goals could be 3-4 years.
To benefit from bond markets, you can thus consider investing in liquid funds and short-term debt funds. If you are considering investing in debt-based mutual funds, you can benefit from short-term investments.
Mutual funds offer automatic diversification. A mixed basket of assets can protect your investments from market losses. As you diversify your investments, you will be able to manage your risk and return much more efficiently.