Should I start an SIP in small cap fund?

Systematic Investment Plans (SIPs) offer investors a convenient and disciplined approach to potential wealth creation. However, when it comes to choosing a suitable mutual fund category for SIP investment, investors often face a dilemma. One such category is small-cap funds. These funds predominantly invest in the stocks of small-cap companies, which are ranked 251 and beyond based on their market capitalisation.

But is a small-cap SIP the right investment choice for you?

In this article, we will explore whether starting an SIP in a small-cap fund is a suitable investment strategy.

• Table of contents

1. Understanding small cap funds
2. Growth potential of small cap funds
3. What are small cap index funds?
4. Volatility and risk of small cap funds
5. Ideal investment horizon
6. Diversification and asset allocation
7. Historical performance and fund selection
8. Regular monitoring and review

Understanding small cap funds

Small-cap funds are mandated by SEBI to invest at least 65% of their assets in the stocks of small-cap companies. These companies are ranked 251 or beyond in terms or market cap and are usually still in their early years. Since the companies are not yet well established, they are also vulnerable to high market volatility. Small-cap funds aim to capitalise on the growth prospects of these companies.

Growth potential of small cap funds

Investing in smaller companies at an early stage of their growth trajectory can result in potentially significant wealth creation. Through SIPs, investors can also benefit from rupee-cost averaging, where they buy more units when prices are low and fewer units when prices are high. This averaging effect can mitigate the impact of market volatility on investments. Therefore, SIPs can be a suitable way of investing in small-cap funds as they average out the cost of investment in the long run despite the prevalent volatility.

What are small cap index funds?

Small cap index funds aim to replicate the performance of a specific small-cap stock index, such as the Nifty SmallCap 250 or the BSE Small Cap Index. Small cap index funds invest in a diversified portfolio of small-cap stocks in weightages similar to the index they track, subject to tracking error.

Small cap index funds offer investors a convenient and cost-effective way to gain exposure to the small-cap segment. With their passive management approach, broad diversification, and long-term growth potential, these funds can be a suitable addition to a well-balanced investment portfolio.

Volatility and risk of small cap funds

Small-cap funds come with higher volatility and risk compared to large-cap or mid-cap funds. The performance and returns of small-cap stocks can be more susceptible to market fluctuations and economic downturns. Therefore, investors should be mentally prepared to withstand major fluctuations in the value of their investments and maintain a long-term perspective to ride out market cycles effectively. In other words, small-cap SIPs may be suitable for investors with a high risk appetite.

Ideal investment horizon

Starting an SIP in a small-cap fund can be suitable for investors with a long-term investment horizon. Since small companies take time to realize their growth potential, investors should be prepared to stay invested for several years to reap the potential rewards. Also, a longer investment horizon allows investors to benefit from the power of compounding, where returns on investments are reinvested to generate additional returns over time.

Diversification and asset allocation

While small-cap funds offer the potential for high returns, investors should consider them as only a portion of their overall portfolio. Diversification across different asset classes, including large-cap, mid-cap, and debt funds, is essential to manage risk effectively. Hence, before committing to a small-cap SIP, investors should assess their risk tolerance, financial goals, and investment objectives and chalk out a broader investment strategy.

Historical performance and fund selection

Before starting SIP in small-cap fund, investors should conduct thorough research on different funds available in the market. It's essential to analyse the historical performance, fund manager's track record, investment philosophy, and portfolio composition of each fund to make an informed decision. Additionally, it is also important to check the expense ratio as this can impact your net returns.

Regular monitoring and review

After making an SIP small-cap fund investment, investors must monitor the portfolio and review their evolving financial goals and risk tolerance. Periodic reviews allow investors to make necessary adjustments to their SIPs and portfolio allocation based on changing market conditions and personal circumstances.

Using an SIP calculator can help investors assess if their investments are performing along expected lines. The calculator helps you estimate the potential final value of your corpus based on your SIP amount, tenure and expected returns. Periodically comparing the portfolio against these estimates can give investors an idea of their investment's performance. However, investors must note that temporary fluctuations and ups and downs are part and parcel of investing in the stock market. Underperformance over a longer horizon, however, may be a cause of concern. Consulting a financial advisor is recommended.

Conclusion

Small Cap SIPs can allow investors to access the potential for significant wealth creation, although with high associated risks. Before investing, it's essential to understand the high-risk nature of small-cap funds and maintain a long-term perspective. It is also important to practice diversification and asset allocation. Consulting with a financial advisor can also provide useful insights and guidance tailored to individual investment goals and preferences.

FAQs

Are small-cap SIPs risky for investors?

Small-cap funds invest in the stocks of small-cap companies making them inherently more volatile compared to large-cap or mid-cap funds.

Who should invest in small-cap funds via SIPs?

Investors with a high risk appetite and long time horizon can consider allocation a part of their portfolio to small-cap funds via SIPs. Investors can also consider a top up SIP in small cap funds, where SIP contributions automatically increase at percentage of your choice at regular intervals. A top up SIP calculator helps you assess the potential returns of such an approach.

Which is a suitable small-cap fund to invest?

Fund suitability depends on individual objectives, preferences and risk tolerance. You can consult a financial advisor for tailored investment advice.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.
This document should not be treated as endorsement of the views/opinions or as investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.