Are Mutual Funds Safe Against a Bad Stock Crash?

Investors need some faith in the stock market to buy into a mutual fund. The fund industry advertises the benefits of professional management and diversification, or spreading your money across many different securities to lessen risk. This doesn't mean risk disappears, your mutual fund will never lose value or a market crash won't take your hard-won investment money along with it.

Diversification

Mutual funds offer a large, diversified group of investments. In theory, if one of the fund's holdings declines, a rise in others should offset the loss. Also, a mutual fund's value might not vary as much as a single stock's. On any given day, you may win or lose in a mutual fund, but you won't see your investment clobbered by unpredictable and bad news from a single company. However, a general market crash poses a very different degree of risk to funds.

Broad Market Declines

If the entire stock market heads south, your fund can suffer the same heavy losses as a small group of stocks, or an individual stock. A mutual fund may take longer to recover, too. A flight by frightened investors to safer investments -- such as cash, certificates of deposit or money market funds -- would depress the price of shares for several weeks or months. Your mutual fund account is not guaranteed against a loss caused by a market decline. A federal agency, the Securities Investor Protection Corporation, only insures against loss from fraud or misappropriation, and only up to $500,000 per account.

Inflation and Management Risk

There are other risks in mutual funds besides a market crash. If inflation picks up, the market stagnates and your fund doesn't return at least the inflation rate, your investment is losing value. If your mutual fund suffers from poor management, there are plenty of competitors willing to accept new investors. A wave of redemptions by unhappy shareholders can force a fund to raise cash by selling its investments. This will affect the investment return and, in an extreme case, could force the fund to shut down or merge with a bigger fund.

Index Funds

It's difficult to time the market and buy and sell shares at just the right time, even for a fund manager. According to an analysis of the mutual fund industry by Goldman Sachs, nearly two-thirds of all actively managed funds failed to beat the 16 percent return in the Standard & Poor's 500 stock index in 2012. Investors who at least want to keep pace with the market, could buy shares of an index fund, which matches the performance of a key stock index such as the S&P 500. Index funds relieve you of the uncertainty of selecting a fund based on its past performance. They also charge lower fees, since the fund managers simply maintain a portfolio according to the index and don't have to spend your money on research and related expenses.