How Mutual Funds Perform During Market Crashes?
A market crash is the worst fear of any investor. Gains made over the years get wiped out in days, and portfolios go red. While nobody wants markets to nosedive, a crash is inevitable in markets, which go through cycles. Like other financial instruments, mutual funds are affected during a crash, and their performance takes a hit. How? Let's find out.
Performance of Mutual Funds During Market Crashes
NAV of Mutual Funds Come Down
NAV, or net asset value, is the unit price of a mutual fund. The value of your mutual fund holdings depends upon the fund's NAV. When NAV comes down following a crash, so does your investment’s worth. Let's understand it with an example. Suppose a fund's NAV before a crash is 50, and you have 1000 units of it. So, the value of your investment is Rs 50,000 (50 X 1000).
However, following a crash, if NAV drops to 40, then the value of your investment drops by Rs 10,000 to Rs 40,000 (40 X 1000).
Stocks Take a Hit and So Do Funds
The underlying securities of mutual funds comprise stocks from different companies. Due to this, mutual funds offer you the benefit of diversification. However, during a market crash, stock prices come down.
This, in turn, pulls down the performance of mutual funds holding these stocks. Companies, too, face a tough time with their operations taking a hit, and it takes time for stocks to recover. Performance improves only when stocks recover lost ground.
Give the Benefit of Rupee Cost Averaging
While the performance of mutual funds during a market crash, if you are investing via systematic investment plans (SIPs), you reap the benefit of rupee cost averaging. It means you gain more units of a fund during a crash. Let's see how. Suppose you invest Rs 1000 in a fund whose NAV before a crash is 10. In such a scenario, you get 100 units of the fund (1000 /10).
If NAV drops to 5 following a crash, you get 200 units of the fund (1000 / 5). This averages out the cost of buying with time. When markets recover, you benefit from acquiring these extra units at a lower NAV at the same invested price.
Approach to Mutual Fund Investment During a Crash
While market crashes inevitably impact mutual funds' performance and pull them down, as an investor, you need to remain patient and avoid exiting your investment. If you redeem your investment during a market crash, you essentially convert your notional losses into actual ones.
Mutual funds are long-term investments, and it's important for you to remain calm during a crash. You need to stay invested and take advantage of rupee cost averaging. Markets have rewarded those who have not pulled out of their investments.
For example, when markets fell 38% during the 2020 Covid crash, some funds compounded investors' wealth by 14% or even more. Also, on several occasions, markets have recovered lost ground much more quickly, rewarding those who displayed patience during turbulent times.
Summing it Up
As an investor, there's little you can do to prevent a crash and a subsequent plummeting of funds' performance. What you can do, however, is to stay calm and not exit your investment. By doing so, you give yourself the chance to benefit from the market rally and boost your wealth.
