Mutual funds are attractive investment vehicles offering a diversified portfolio to buy into. However, savvy investors always want to fully understand the risks of every bit of investment. So, can mutual funds drop to zero? How often do they fail?
A mutual fund can theoretically drop to zero, but the possibility of this happening is extremely low. For a mutual fund to drop to zero, all the securities in the fund must deteriorate to bankruptcy. Mutual fund failure is more common, but it is subjective. Investment goals differ across clients.
In this article, I’ll cover all you need to know about mutual funds failure and the possibility of losing all your money.
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Table of Contents
Can Your Mutual Funds Investment Go to Zero?
On paper, almost every investment can fall to zero. If you buy Apple stock today and the company somehow goes bust, the value of your investment will turn to zero. How likely is it for Apple to go bust, though? Your guess is as good as mine.
Now, the above example is for a single security. A standard mutual funds investment will have dozens or hundreds of securities (in the case of index-tracking funds). Therefore, for your investment to go to zero on a mutual fund, every single company behind each of the securities has to go bankrupt.
Again, I don’t see that happening, barring any events of apocalyptic proportions. One or two companies can go bankrupt, but all of them can’t.
The only exception is if you’ve invested in a poorly diversified mutual fund featuring dozens of new and unknown companies. That’s a very risky portfolio and a discussion for another topic.
If you’ve invested in a properly diversified mutual fund with years of history behind it or a fund that tracks an index like the S&P 500, for example, it’s nearly impossible for your investment to go to zero.
Let’s assume you buy into a mutual fund that invests 70% into small-cap stocks and 30% into AA-rated bonds. For your investment to drop all the way to zero, all the small-cap businesses behind the stocks have to shut down, and the value of the AA-rated bonds has to become zero.
That’s a lot of low probability events happening at the same time. All those companies won’t go belly up simultaneously, and AA-rated bonds going to zero means a crashed economy. So, while there’s always the possibility of your mutual funds crashing, the chances of that happening is infinitesimal.
How Often Do Mutual Funds Fail?
As I mentioned at the start, this is a subjective question. If you’re thinking about failure in terms of the fund folding up and disappearing with your money, it’s not very common at all. If you’ve invested with a regulated investment company, you’ll get your money back in such a situation. However, when it comes to generating negative returns from time to time, that’s fairly common. Again, what qualifies as poor returns will vary across different investors.
While some investors won’t mind a financial year ending with a return of -20%, others will immediately think of the fund as a failure at -10%. Some will exit the fund if it misses the projected mark at the end of a year or two—even if those years ended in marginal profits.
Unfortunately, negative returns and general disappointments are fairly common in the mutual funds world—especially in the actively managed mutual fund niche.
A report from 2017 showed that most mutual funds failed to beat the market (basically beating the returns of the S&P 500) over a 15-year window. Looking at how some actively managed funds are sold, such results will look like failure for many clients. If you’re looking at mutual funds failure in this light, then the answer to “how often do mutual funds fail?” is “regularly.”
If you’re an investor that doesn’t mind the ups and downs that come with an investment like this, you’d be less likely to call your investment a failure after a year of missing the returns mark or generating negative returns.
For such investors, mutual funds don’t fail often. Even when business problems force mergers and acquisitions, your investments will largely stay unaffected.
What To Do After Your Mutual Fund Investment Drops in Value?
I’ve reassured you about the chances of your investment falling to zero. However, your investment can drop in value by up to 20% or more. What should you do in this situation?
Don’t Panic Sell
If you invested $100,000 and it declines to $80,000, it is natural to feel a bit uncomfortable. However, selling off or exiting from the fund shouldn’t be the first thing on your mind. As long as you don’t sell, the $20,000 loss remains notional.
As the markets recover, the losses can reduce. You may also gradually enter into profits. If you sell the investment in panic, you’ll book the loss and miss out on the opportunity of recovery.
Some people make the mistake of booking the loss to wait “until the market recovers.” That’s a move that puts you at a disadvantage. The market recovery is the time to recover the loss.
Getting back in with your fund after it has recovered means you’ll be looking to recoup losses as other investors start to see profits.
Analyze the Investment
If you’re invested in a mutual fund tracking the index like the S&P 500, there’s nothing much you can do in a bearish market except waiting it out. For other types of mutual funds, a bearish market may be time for fresh analysis.
Evaluate the portfolio holding to see if it can come through the bearish period unscathed. If you don’t have the skills to analyze the investment, call in a manager to help you work out if the investment is worth holding or not.
Keep Your Investment Goals in Mind
Most mutual fund investors have a 5-10 year target. If you originally got in for the long term, it makes sense to remind yourself of that goal in a bear market. If the fundamentals supporting the mutual fund haven’t changed a great deal since you first bought it, sticking to your goals is often a better idea.
Adjust for Volatility
Elections, pandemic years, and economic crashes typically cause extreme volatility. Reacting to negative downturns in portfolio value during this period is almost always the wrong move because the markets have shown time and again that they can bounce back from such periods.
Before you exit the investment, look at other investment alternatives to see how they are faring. If results have taken a hit everywhere, there’s nothing else to do.
I always point to the S&P 500 as an example when discussing extreme volatility. In 2020, any fund tracking it would have lost 25% of its value by the end of March.
If you exited such a fund at the peak of the drawdown, you’d have missed out on the 40% rally between April and December to end the year at a 15% profit.
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Conclusion
Mutual funds may not always deliver in line with your expectations. However, it’s near impossible for any of them to fall to zero as long as you’ve invested with a legitimate and regulated investment company. I can’t remember any such cases. Even when hedge funds go belly up for other reasons, you’ll either get your funds back or have the investments merged elsewhere.
The worry about performance is often strongest with actively managed funds. Passively managed funds tracking a major index are highly diversified and will almost always recover from any major drawdowns.
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