Many investors consider small-cap funds a high-risk and high-reward investment. This is because the funds are invested in companies with smaller market capitalization, which can provide stellar returns as they mature but have significant risks owing to market volatility.
In this blog, we discuss how the risk and reward in small-cap funds can be balanced and why these funds should be considered in the investment portfolio.
What Are Small-Cap Funds?
Small cap funds focus their investments on the shares of small cap companies, i.e. those businesses ranked beyond the top 250 companies in terms of market capitalization. These companies have good growth potential, but their performance tends to be very erratic which makes these funds one of the most risky classes of equities.
Small cap funds are ideal for investors who:
- Have a very high risk appetite.
- Are looking for long term investment for 5 to 10 years.
- Wish to see their portfolio grow aggressively.
The Rewards of Investing in Small-Cap Funds
Let’s look into the rewards of investing in these funds:
1. High Growth Potential
Small-cap companies are still at the beginning stage of their growth trajectory. Successful businesses have the possibility of expanding significantly and providing a good return in the long run.
2. Diversification Benefits
When you put money into small cap funds, it helps you spread out the risk in your equity portfolio by diversifying outside the large and mid-cap segments and thus increasing growth potential.
The Risks of Small-Cap Funds
Let’s look into the risks of investing in these funds:
1. Market Volatility
These funds are relatively riskier when it comes to market changes and sell-offs, thus exhibiting greater short-term fluctuations than those with large-cap profiles.
2. Liquidity Issues
These funds have thin trading volumes; therefore, there might be difficulties in placing and filling orders for or selling large amounts during bears.
3. Company-Specific Risks
Macroeconomic conditions, rivalry, and operational inefficiencies have the potential to significantly affect the financial performance of small-cap firms.
How to Balance Risk and Reward in Small-Cap Funds
Let’s explore how to balance risks and rewards of these funds:
1. Choose the Right Fund
Selecting a high-quality small-cap fund is crucial. Look for funds with a strong track record of consistent performance and robust risk management. For instance, the Edelweiss small cap fund has earned recognition for its disciplined investment strategy and focus on identifying promising small-cap opportunities.
2. Diversify Across Funds
While small-cap funds can deliver high returns, they should only form a portion of your equity portfolio. Balance them with some of the best equity funds with balanced risk and reward to spread risk across various market segments.
3. Invest with a Long-Term Perspective
Small-cap funds require patience. Volatility is inevitable in the short term, but the potential for growth over 5-10 years makes them a rewarding investment for long-term investors.
4. Use Systematic Investment Plans (SIPs)
SIPs allow you to invest a fixed amount regularly, which helps average out the cost of purchase during market highs and lows. This disciplined strategy reduces the impact of short-term volatility.
5. Monitor Fund Performance
Regularly review the performance of your small-cap funds to ensure they align with your financial goals. However, avoid making decisions based on short-term fluctuations.
6. Understand Your Risk Appetite
Assess your risk tolerance and allocate funds accordingly. Small-cap funds are not for risk-averse investors or those with a short investment horizon.
Final Words
Balancing risk and reward in small-cap funds requires careful planning, diversification, and a long-term perspective. By integrating these funds into a well-diversified portfolio, you can achieve higher returns while managing market risks effectively.
