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Small-cap secrets: Are investors prepared for a rollercoaster of riches?

Small-cap secrets

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Small-cap mutual funds, a category of equity mutual funds, have been making waves in India despite the high risks involved. In June 2023, small-cap fund inflows reached the ₹5,472 crore mark, contributing significantly to the ₹8,245 crore net inflow in equity mutual funds. Investors must conduct a well-researched risks versus benefits analysis of investing in small-cap mutual funds before investing in this high-risk category of equity mutual funds.

The lesser-known secrets of investing in a small-cap fund:

1. Investors can earn exceptionally high returns compared to mid- or large-cap funds:

Small-cap stocks represent companies with relatively low market capitalization; hence, they have more room for growth when compared to their larger counterparts. While the higher risk associated with small-cap stocks might deter some investors, those willing to embrace the volatility often reap the rewards.

2. Investors who invest in small-cap funds pay low NAVs:

Small-cap funds are also known to offer a lower NAV (Net Asset Value) compared to mid- or large-cap funds. The NAV is the price at which an investor purchases or sells their mutual fund units. Investors must refrain from interpreting low NAV values as signs of efficient mutual fund investments and must analyse the previous performance of a fund to judge its efficiency.

3. Small-cap mutual funds help investors diversify:

Investors must prioritise diversification if they wish to minimise the overall risk of their investment portfolio and grow their annual earnings. Small-cap stocks often move independently from mid-cap and large-cap stocks, offering a buffer against market volatility.

Investors must be conscious of the following risks:

1. The performance of small-cap funds is very volatile:

Small-cap funds offer higher returns; however, they are also very volatile. Several factors affect the performance of small-cap stocks such as the economic conditions in a country and changes within a company’s organisation. Investors must therefore remember that small-cap funds are extremely volatile in nature.

2. Small-cap funds offer less liquidity:

Small-cap stocks offer lower liquidity since they have lower trading volumes. Investors must have a sufficiently large emergency fund before making a small-cap fund investment since these funds do not offer high liquidity. Investors find it difficult to sell small-cap fund units without considerably affecting the market price. Small-cap funds are, therefore,ideal for investors with a longer investment duration who can handle longer periods of lesser access to liquidity.

3. The performance of small-cap funds is unpredictable:

Investors must learn about the market conditions that impact small-cap funds and define their volatile nature. The performance of small-cap mutual funds is, therefore, not predictable either.

Who must invest in a small-cap mutual fund?

Investors must conduct a detailed analysis of their risk-taking capacity before making a small-cap fund investment. Small-cap mutual funds can add great value to an investment strategy by increasing the potential for high returns. However, investors with low risk-taking capacities and those looking to invest for the short term must allocate a limited portion of their portfolio to small-cap funds. These investors must look to balance their overall risk and increase the stability of their portfolio by making more prudent investment choices. They must analyse their risk-taking capacity, short-andlong-term financial goals and their investment horizon before investing in small-cap funds. An SIP calculator can also be utilized to draw investment plans that align with their investing profile.

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