Is it the right time to invest in small-caps?

As markets continue to be on a high,investors are wary of entering the markets at these levels. But those with FOMO – Fear of Missing Out – choose to invest through smallcap stocks. They do this under the assumption that small caps may still have some steam left in them and playing catching up with the rally.

But is this really the right time to invest in these stocks?

Characteristics of small-cap stocks

Small caps are defined (by SEBI) as those that are ranked 251st and above based on their market capitalization.These are stocks of companies that are not big names in the sectors that they operate, are not well-established and/or have a largely inexperienced management team. Owing to their small size and depending on the nascency of their business, these stocks could drastically be affected by economic cycles, and therefore, carry high risk.

In a declining market, small caps are usually the first casualties as investors and traders fearing further losses rush to get them off their hands. Vice versa, in a rising market, they rush to stock up on the small caps. Therefore, they tend to fluctuate heavily with market movements, and hence, are extremely volatile in nature.This makessmall caps or funds that invest in small caps is well suited for investors who have the necessary risk tolerance.

The last one year has seen heavy volatility in stock markets, owing to the Covid-19 pandemic and the ensuing global lockdown. The BSE Sensex at the start of the year fell to multi-year lows and by the end of the year was crossing all-time highs consistently. Given such volatility, the S&P BSE Sensex grew by about 24% since January 2020 while the S&P BSE Small Cap index grew by about 45%.

Investing in smallcap funds

Although small caps have the scope to outperform large caps and deliver high returns, picking the right stocks is of the essence as not all stocks perform uniformly even during phases of high economic growth. In such a scenario, it would be a good idea to opt for a small-cap fund rather than picking up individual stocks, because with a mutual fund, you have access to the expertise of fund managers who can cherry-pick select stocks from the huge universe of small caps.

Further, given the current valuations with markets at record highs, it may not be an ideal time to invest a lump sum in small-cap funds. This is because smallcaps typically perform very well during bull markets but tend to be volatile in a bear market. In such a scenario, investors may invest in them in a staggered fashion over the long term. An SIP in a small-cap seems ideal in such a scenario as it helps make the most of volatility by regularly investing your money across market cycles.

Investors may dedicate a small portion of their portfolio, say 10-15%, to small-cap funds to diversify their portfolio risk and at the same time, participate in the small-cap category to earn additional returns. It must be borne in mind, however, that small-cap funds are meant to perform over the long term and only those investors who have an investment horizon of at least 5 to 7 years should invest in this category.

Although small-capshave grown considerably in recent months,the category still offers room for growth, given the low interest rate environment and risk-on sentiment among investors. Investors may consider start an SIP in small-cap funds to ensure that they capture growth opportunities in this segment.

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