For investors who are looking forward to diversifying their portfolio or stepping into the dynamic world of the stock market often tend to consider a wide variety of options for investment, including small-cap, mid-cap, and large-cap. However, as far as Equity Mutual Fund is concerned, small-cap funds stand as a compelling option for individuals intending to balance their risk and reward.
This is because small-cap funds concentrate on investing in companies that entertain relatively smaller market capitalisation and which are often overlooked by institutional investors who play on a large scale. Let’s know more about what small-cap funds are and what the risks and rewards are that one may secure by investing in Small Cap fund.
What Are Small Cap Funds?
Small-cap funds are a particular kind of mutual fund or ETF (Exchange Traded Fund) that aims at investing in companies and stocks with relatively small market capitalisation. Market capitalization stands for the total value of the outstanding shares of a company’s stocks, which is multiplied by the current market price per share.
As compared to large-cap and mid-cap companies, small caps typically fall in the range of lower market capitalization range, and these are considered to be in the early stage of development and growth. This is because they retain higher growth potential than larger and more established companies.
How Can Investors Benefit From Investing In Small Cap Funds?
Making investment in small-cap funds offer a plethora of benefits to individuals who aim to diversify their portfolios and secure significant opportunities for growth. Let’s look at some of the key benefits offered by small-cap funds:
High Potential For Growth:
As small-cap companies often remain in the early stages of their growth, they entertain the possibility of achieving rapid extension. The small size allows them to capitalise on new niches, emerging trends, and innovative products in the market. This leads to a substantial increase in the price of the stocks that ensures more profit to the investor.
Lack Of Representation On Mutual Funds:
A large number of shares of companies are generally purchased by mutual funds in which they invest. Therefore, most companies with low market capitalisation don’t form a part of mutual funds as the total number of stocks available is limited.
Therefore, this opportunity can be taken by individual investors who identify an opportunity for growth and make investments before the stock gets attention from the market.
Long-Term Growth And Increased Valuation:
As small cap stocks don’t get that much attention from the market, the stock remains undervalued, unlike large and mid cap stocks, which makes the stock price much lower than the real value. The valuation of the stocks may increase in the long term when it reflects its real value in the market, and this helps an investor to book large amounts of profits.
Adaptability And Flexibility:
It is easier for smaller companies to adapt to the dynamic conditions of the market, which helps the investors to secure golden opportunities or refine their strategies as required. This may enhance growth potential significantly.
What Are The Risks That investors Must Be Aware Of While Investing In Small Cap Funds?
Although small cap funds offer a wide range of benefits, it is essential for investors to be aware of the risks involved in investing in small cap funds, these are:
Small cap stocks usually experience greater price volatility than larger stocks of more established companies. This volatility may stem from a number of factors, such as lower trading volumes, limited resources, and enhanced market sensitivity to news, as well as economic conditions. Sudden price fluctuations may offer substantial price gains but also significant losses in several cases.
Low Market Liquidity:
Another risk posed by small cap funds is that they often suffer from low market liquidity. As smaller companies have low trading volumes, it eventually gives way to lower liquidity, making it challenging for investors to buy and sell small cap shares at the desired price, especially during a crisis in the market. This may lead to higher costs of trading and difficulty in the execution of timely transactions.
Higher Business Risk:
As small cap companies are typically in their early stages of growth, they often tend to lack the stability in finance that large companies usually entertain. This makes them more susceptible to economic downtowns, business setbacks, and challenges specific to that particular industry. An adverse event may have a more significant impact on a small cap company’s stock price.
It is now clear that small companies have limited financial resources, but it is also essential to note that it makes it challenging for them to cope with unexpected expenses or invstments in innovation. The lack of resources may hinder their competing ability in their respective markets.
Therefore, to mitigate the risks of investing in small cap companies. Investors may adopt several strategies that might prove helpful. This involves diversification of stocks across a number of companies, conducting thorough research, and securing a thorough understanding of one’s risk tolerance capability.