ARTI ARORA CFP CM | HEAD FINANCIAL PLANNER

There is a thin line of difference between taking risk and taking calculated risk. Making a choice between small cap stocks and small cap funds defines this thin line quite well.

Let us first define small cap companies. Companies with market capitalization of less than Rs.5000 crore are small cap companies. When one invests in such a company, it is said to be an investment in a small cap stock. Likewise, small cap mutual funds also invest in small cap companies, the only difference being that these funds are professionally managed by highly experienced and qualified fund managers.

Investing in small caps is a high return high risk proposition and there are some points that one must always bear in mind –

  • Invest in Small caps only when your investment horizon is more than 5 years. If you have your financial goal due within 5 years, small caps are a strict no-no.
  • Make small caps a part of the satellite portfolio and not of core portfolio. The satellite portfolio is reviewed more frequently so that corrective action with respect to profit booking or stop loss can be taken as and when required without having to compromise with one’s financial goals.
  • Limit the small cap exposure to not more than 15-20% even as part of the satellite portfolio. This is a broad guideline and there can be variation in this depending on one’s own risk profile.

When it is about a choice between small cap stocks or mutual funds, we advise investment in latter. Small cap mutual funds are preferred over small cap stocks because of several reasons and we shall explain some of these reasons briefly.

Small cap mutual funds though high in risk are less risky than small cap stocks because they diversify their investments across different small cap companies rather than concentrating it in one stock. By pure logic, this makes small cap funds a comparatively lower risk proposition.

The small cap funds are managed by highly competent fund managers who take investment decisions only after thorough research, analysis and after taking in consideration other necessary parameters. They diversify their investment across different sectors and take well informed investment calls. This kind of in-depth study and research cannot be carried out by any individual investor which is another reason why investing in small cap funds is advisable or favored to investing in small cap stocks.

A recent article delved upon how the pharma mutual funds have fared better in terms of returns than pharma stocks and there are figures out there to validate this. On similar lines, even when you are tempted by higher return potential in a particular small cap stock, control it. It is always better to assess the pros & cons of any decision specially investment decision. So, while that tip about a small cap stock may be tempting, it may not be rewarding and in fact can be draining.

All in all, between small cap stocks and small cap mutual funds, it is advisable to invest in the latter for very simple reasons as detailed above until and unless you are an expert trader or a research analyst who is highly confident about the investment call being correct, our suggested approach shall suit you better in all seasons and in all circumstances.