How do stock market crashes impact mutual fund investors?

The Indian equity market recently experienced a significant downturn, with benchmark indices like Nifty 50 and Sensex falling 10-11% from their September 2024 peaks. By April 2025, the damage has been even more severe in mid and small cap segments, which have plummeted by nearly 18% from their highs. This crash has wiped out approximately Rs. 94 lakh crore of investor wealth in just five months, leaving many mutual fund investors questioning their investment strategies and wondering whether to stay the course or exit.

As you navigate this turbulent market environment, understanding the dynamics of market crashes and their specific impact on mutual fund investments becomes crucial. While market volatility is inevitable, your response to it will largely determine your long-term financial outcomes.

• Table of contents

• What is a stock market crash?
• Mutual funds’ reaction to market crashes
• Types of mutual funds most affected
• How does NAV and investor returns get affected?
• Long-term vs. short-term consequences
• How to protect your mutual fund investments?
• Should you exit or stay invested?

What is a stock market crash?

Stock market crashes don't happen randomly—they're typically triggered by a combination of economic, psychological, and systemic factors that create perfect storms in financial markets. Understanding these causes can help you anticipate potential downturns and prepare your investment strategy accordingly.

Economic contractions are common triggers for market crashes. When an economy slows down, businesses generate lower revenues, unemployment rises, and consumer spending declines. These factors erode investor confidence, leading to widespread sell-offs.

The recent market crash has been partly attributed to concerns about a potential economic slowdown, with investors becoming increasingly risk averse.

Market crashes often follow periods of irrational exuberance where asset prices rise far beyond their intrinsic values. When these speculative bubbles eventually burst, prices plummet rapidly. The Indian equity market reached its peak in late September 2024, with numerous stocks across large cap, mid cap, and small cap segments hitting lifetime highs before the subsequent correction.

External events such as wars, natural disasters, or pandemics can disrupt markets by creating uncertainty and reducing economic activity. The recent market volatility has been influenced by global trade tensions and geopolitical uncertainties that have made foreign investors more cautious about emerging markets like India.

Also Read: Navigating a bear market

Mutual funds’ reaction to market crashes

Mutual funds, as collections of securities, inevitably reflect broader market movements during crashes. However, their reactions vary based on fund type, investment strategy, and portfolio composition.

The most direct impact of a market crash on mutual funds is the reduction in their Net Asset Value (NAV). As the underlying securities lose value, the fund's NAV decreases proportionally. This decline can be alarming for investors who see their investment values drop, sometimes substantially, over short periods.

Market crashes often trigger panic among investors, leading to increased redemption requests. Fund managers may be forced to sell holdings at unfavourable prices to meet these redemptions, potentially exacerbating NAV declines. This can create a negative feedback loop where selling pressure drives prices lower, triggering more redemptions.

During market downturns, fund managers typically reassess their portfolios and may rebalance holdings to limit losses or capitalise on opportunities. Funds with flexible mandates might increase cash positions or shift toward more defensive sectors. This rebalancing can help cushion the impact of the crash and position the fund for recovery.

Not all mutual funds react identically to market crashes. Some funds demonstrate greater resilience, while others experience more significant declines. For instance, during the recent market correction, large cap funds and those with value oriented approaches have fared relatively better than mid cap and small cap funds.

Types of mutual funds most affected

The impact of a market crash varies significantly across different mutual fund categories, with some experiencing more severe effects than others.

Equity funds

Pure equity funds, particularly those focused on growth stocks or aggressive sectors, typically experience the most significant impact during market crashes. Within this category -

• Small cap and mid cap funds: These funds have been the hardest hit during the recent market correction, with declines ranging from 4% to 26% over the past five months. Their higher volatility stems from the lower liquidity and greater sensitivity to economic changes of their underlying holdings.
• Sector-specific funds: Funds concentrated in specific sectors can face amplified losses if their focus area is particularly affected by the market downturn. During the recent crash, technology and consumer discretionary sectors have experienced significant pressure.
• Large cap funds: While still affected by market crashes, large cap funds typically demonstrate relatively more stability due to the established nature and stronger balance sheets of their underlying companies. In the recent correction, large cap funds have generally fared better than their mid cap and small cap counterparts.

Hybrid funds

Hybrid funds, which combine equity and debt instruments, generally offer better protection during market downturns.

• Balanced funds: With their mix of stocks and bonds, balanced funds can cushion market volatility, making them less severely impacted during crashes. The debt component provides stability when equity markets decline.
• Dynamic asset allocation funds: These funds adjust their equity-debt mix based on market conditions and may reduce equity exposure during downturns, potentially limiting losses during crashes.

Debt funds

Fixed income funds typically experience less direct impact from equity market crashes, though they may face challenges if the crash coincides with interest rate changes or credit concerns.

• Government securities funds: These are generally the least affected by stock market crashes and may even benefit from "flight to safety" capital flows.
• Corporate bond funds: These may experience some pressure if the crash raises concerns about corporate defaults or liquidity issues.

How does NAV and investor returns get affected?

Market crashes directly affect mutual fund NAVs, which in turn impact investor returns in both the short and long term.

When a stock market crashes, the value of securities held by mutual funds decreases, causing a corresponding reduction in NAV. For example, if a fund's NAV before a crash is Rs. 50 and you hold 1,000 units, your investment is worth Rs. 50,000. If the NAV drops to Rs. 40 following the crash, your investment value decreases to Rs. 40,000—a Rs. 10,000 reduction.

It's crucial to understand that NAV reductions represent notional losses unless you redeem your units. If you sell during a downturn, you convert these notional losses into actual ones. This distinction is fundamental to making sound decisions during market crashes.

Psychological effects on mutual fund investors

During market crashes, fear becomes the dominant emotion, often leading to panic selling. This emotional response can cause you to exit investments at their lowest points, locking in losses rather than waiting for recovery. The recent market downturn has already led to increased SIP cancellations as investors react emotionally to portfolio losses.

Investors typically feel the pain of losses more acutely than the pleasure of equivalent gains—a phenomenon known as loss aversion. This psychological bias can drive impulsive decisions during market crashes as you attempt to avoid further losses, even when staying invested might be the more rational choice.

During market crashes, investors tend to overemphasise recent events, leading to excessive pessimism. This recency bias can cause you to project current negative trends indefinitely into the future, ignoring the cyclical nature of markets and their tendency to recover over time.

Also Read: How does investor behaviour impact market conditions?

Long-term vs. short-term consequences

The impact of market crashes differs significantly depending on your investment timeframe and how you respond to the downturn.

Short-term consequences

• Portfolio value reduction: Your investment value may decline substantially, creating financial stress and uncertainty.
• Liquidity constraints: If you need to withdraw funds during a crash, you may face unfavourable redemption values.
• Emotional distress: The psychological impact of seeing your investments lose value can be significant, potentially affecting your overall financial confidence.

Long-term consequences

• Buying opportunities: Market downturns create opportunities to acquire fund units at lower NAVs, potentially enhancing long-term return.
• Portfolio rebalancing: Crashes provide natural opportunities to reassess and rebalance your investment strategy.
• Learning experiences: Navigating through market crashes can build investment discipline and emotional resilience, improving your long-term investment approach.

How to protect your mutual fund investments?

While you can't prevent market crashes, you can implement strategies to mitigate their impact on your mutual fund portfolio.

Maintain your asset allocation strategy

Adhering to your predetermined asset allocation based on your financial goals and risk tolerance provides stability during market turbulence. Resist the urge to dramatically alter your strategy in response to short-term market movements.

Continue SIP investments

Maintaining your SIP during market downturns allows you to accumulate more units at lower NAVs, potentially enhancing returns when markets recover. For example, if you invest Rs. 10,000 monthly and the NAV drops from Rs. 500 to Rs. 400, you'll purchase more units, positioning yourself for higher returns during the recovery phase.

Diversify across fund categories

A well-diversified portfolio spread across different fund categories—large cap, mid cap, value based, and hybrid funds—can mitigate overall volatility and limit downside risk during market crashes. Different fund types respond differently to market conditions, providing portfolio stability.

Consider hybrid funds

Hybrid funds, which blend equity and debt, can offer greater stability during volatile periods by providing a cushion against sharp market swings. These funds can be particularly valuable for risk-averse investors seeking balance between growth and stability.

Should you exit or stay invested?

The question of whether to exit or remain invested during a market crash is perhaps the most critical decision you'll face as a mutual fund investor.

The case for staying invested

• Markets have consistently recovered from crashes over time, rewarding patient investors.
• Exiting during downturns converts notional losses into actual ones, eliminating the possibility of participating in the eventual recovery.
• Timing the market—trying to sell before further declines and buy back at the bottom—has proven nearly impossible even for professional investors.

When exiting might make sense

• If your financial circumstances have changed dramatically and you need the funds immediately.
• If your investment goals have shifted significantly, necessitating a complete strategy revision.
• If a particular fund has fundamental issues beyond general market conditions, such as management problems or strategy drift.

Conclusion

The recent market crash that has wiped out almost Rs. 94 lakh crore of investor wealth represents a significant test for mutual fund investors. While the mid cap and small cap segments have been hit particularly hard with declines approaching 18%, this volatility is ultimately part of the long-term investment journey. Historical patterns suggest that market recoveries follow different timelines—from the rapid rebound after the 2020 COVID crash to the five-year recovery period following the 2008 financial crisis.

FAQs:

How does a stock market crash affect mutual fund investments?

A stock market crash directly reduces the Net Asset Value (NAV) of equity-oriented mutual funds as the underlying securities lose value. This causes a corresponding decrease in your investment value. For example, if you hold 1,000 units of a fund whose NAV drops from Rs. 50 to Rs. 40, your investment value decreases by Rs. 10,000.

Which types of mutual funds suffer the most during a crash?

Small cap and mid cap equity funds typically experience the most significant impact during market crashes, with recent declines ranging from 4% to 26%. These funds invest in companies with smaller market capitalisations that tend to be more volatile and less liquid during market stress.

Should I withdraw my money from mutual funds during a market crash?

Generally, withdrawing money during a market crash is not advisable as it converts notional losses into actual ones. Historical data shows that markets eventually recover, and patient investors are typically rewarded. Instead of exiting, consider continuing your SIPs to benefit from rupee cost averaging and potentially enhance your returns when markets recover.

How long does it take for mutual funds to recover after a crash?

Recovery timelines vary significantly based on the crash's severity, underlying causes, and policy responses. Historical examples show this variation: after the 2020 COVID-19 crash, many funds recovered within months; the 2008 financial crisis took about five years for full recovery; the 1987 crash required almost two years; and the 1929 crash took approximately 25 years.

What strategies can help investors minimise losses during a stock market crash?

Several strategies can help minimise losses during market crashes: maintain your predetermined asset allocation based on your risk tolerance and goals rather than making dramatic changes; continue SIP investments to benefit from rupee cost averaging; ensure portfolio diversification across different fund categories and consider having some allocation to hybrid funds that blend equity and debt for greater stability. Regularly review your portfolio but avoid frequent churning; and perhaps most importantly, avoid emotional decision making driven by fear or panic.