Why stock market crashes are good for you

A 22-year old wrote in asking us whether or not he should even consider investing in equity. Looking at the carnage in the markets across the globe, he wanted to know if he was better off putting his money in a fixed deposit or buying a National Savings Certificate (NSC).

Of course, this young man had two great aspects in his favour. He was serious about investing right from his very first job and he was willing stay in for the long haul -- at least 5 to 6 years.

If he invested in fixed return investments like fixed deposits, he would be assured of a rate of return. And he would be assured of his principal being returned. But, a fixed deposit is not a very tax efficient investment (the returns are taxed). Secondly, since he does not need the money in the short-run, there is no need to go for a fixed return investment.

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What stock market investors need is time on their side to ride the ups and downs of the market. And, in the long run, the returns from equity do outweigh debt. Stocks are dangerous short-term bets but excellent long-term investments. So by all indications, he should move into equity.

But what scared him was the current market crash. What every stock market investor must realise is that in the equity market, you make money not despite the crashes but because of them.

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Let's look at the tech boom. The Sensex touched around 5,900 in February 2000 before sinking to 2,600 in September 2001. It touched 6,000 only in January 2004.

Now let's assume that the crash never happened and the Sensex reached 5,600 in March 2000 and stayed at that level till October 2004.

If you had started investing Rs 20,000 per month in a Sensex-based index fund in early 1997 and continued all through, your investments would have been worth Rs 55 lakh (without the crash) instead of Rs 66 lakh (with the crash). The reason?

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The crash enabled the investor to buy cheap and thus eventually raise total returns on their investments.

If you are investing steadily for the long term, then intermittent crashes help you make more money, not less. Because when bubbles correct, they usually overcorrect so that the market is selling well below fair value. So that's the time to go buying, not selling.

And right now, the risk of losing money at 10,000 is certainly much less than when the Sensex was at 20,000.

So as you can see, we advised this young investor to opt for a Systematic Investment Plan (SIP) in a diversified equity mutual fund. In this way, he consistently invests a fixed amount every single month, irrespective of the state of the market. When the market is down, he gets more units for his investment. When it goes up, he gets less. But over the next five years, he would have saved a tidy sum.