Are Mutual Funds Safe Against a Bad Stock Crash?

How mutual funds would perform in a stock market crash depends on the type of funds you own. A fund that invests only in stocks would likely take a much bigger hit than one that holds bonds or a mix of the two investments. However, the last time the stock market truly crashed and stayed down in value for a long period was in 1929. Historically, investors who have ridden out big market drops ended up with more money in their accounts when stocks recovered.

Mutual funds can be broadly broken down into stock and bond funds. Stock funds invest in shares that trade on the stock market. The share value of one of these funds will move up and down with the changes in the prices of the stocks the fund owns. The bonds in a bond fund are fixed-income securities, with values that are not tied to changes in the stock market. If the market suffers a large decline, stock mutual funds will typically drop more than bond funds.

A crash – or the rapid decline in the stock market over a few days – has technically happened twice in the last 100 years, in 1929 and 1987. However, the 1987 drop was a short-term event compared with the '29 crash. The more common bear market typically occurs over a period of months, ending with a large drop in stock values at the bottom of the downturn.

From 1950 through 2013, there have been seven bear markets. The declines during these downturns ranged from 27.8 percent to 56.4 percent below the previous peak in the stock market. The 1987 downturn was about in the middle of the range, with the market declining by 33 percent over a few months.

The stock market has always recovered from crashes and bear markets, then gone on to set new record highs. Mutual fund investors lose money in a bear market if they sell shares when the market is down. Those who don't panic over falling prices have typically seen their investments recover and move higher. That being said, it is important to weigh out risk tolerance relative to your current position in life.

If, for example, you are relatively young and have years of working adulthood ahead of you, a market sell-off might not be so devastating. However, individuals who are nearing retirement could suffer catastrophic damage if their mutual funds are negatively impacted at this phase of their life. With that in mind, you must decide for yourself when the "right" time to sell your investments is. Time must always play a critical role in your investment strategy, as temporary losses can quickly turn into permanent setbacks if you do not have the time needed to wait out a market slump.

A portfolio that includes a mix of investments like stocks and bonds can reduce the pain during a bear market. Splitting your portfolio between different types of mutual funds can help with this. You can also rebalance the amount of money you have in each type of investment. This will help keep each slice of the pie from getting much larger or smaller than you want, based on your long-term goals. With this type of portfolio management, you don't need to fear a stock market crash as much.