Volatility is your friend

Only small cap investing is real stock investing. That sounds like a provocative statement, worded more to surprise than to tell the literal truth. I don't normally like to write such things but I do believe in this one. I'm not saying that buying stocks such as Reliance Industries or ICICI Bank is not equity investing. Of course it is.

What I'm saying that is that if the experience of buying a stock is to reflect owning a business and prospering with it, then the only way to experience it is to buy a small cap and then watch it grow into a midcap and then a large business.

To understand what I'm trying to convey, investors must consider what they expect from equity investing and whether they are willing to put up with the risk and the volatility that is an inevitable part of the same package that also contains great returns. Investment advisors and analysts often ask investors to evaluate what kind of risks they are willing to take in order to have a chance of getting the kind of returns that equity is capable of. It's an open secret that in answering this question, most investors lie to themselves, even if unwillingly.

Small cap stocks and the mutual funds based on them have been going great guns for at least five years now, specially in contrast to the lacklustre performance of the large cap stocks and the funds that invest in them. Fund investors have been pouring money into funds that invest in smaller companies. And they've not been disappointed--you can read about how well these funds have been doing and how you can still land yourself part of the bonanza.

However, to do so and not get spooked by volatility, one must keep the fundamentally volatile nature of small cap investing in mind. When an investment is doing well, it's natural to be full of bravado and be sure that you will take any volatility in your stride because you understand the nature of equity etc., etc. Equity investing seems like the easiest thing and the world, and those who talk of risk and volatility appear to be nervous ninnies. However, when the markets start declining and the value of your investment starts going down every day, then the answer to that question about risk-taking changes, as it should.

When that happens, what should investors do? Should they quit and run (perhaps switching their investment to large cap funds), or should they stick it out? For some investors, if they feel they can't take the volatility, the answer has to be that they should not invest in small-cap funds. However, the right way to approach the whole thing is slightly different. The first principle is also the oldest one, which is diversification.

And the second principal, no less important, is to understand that volatility is actually your friend if you are investing in small cap equities through mutual funds. The universe of small cap funds is much larger than large cap ones and an individual investor cannot make sense of it except through mutual funds. More importantly, only if you invest through an SIP can you benefit from the volatility that is an inherent part of small cap equities. Consider this: over the last five years, a typical high-performing large cap fund (SBI Bluechip) has had simple annualised returns of 15.8% and SIP returns of 19.7%. Over the same period, a typical high-performing small cap fund (Franklin India Smaller Companies) has simple annualised returns of 24.6% but SIP returns of 32.0%. Compare the differential.

Regular SIP investments through a small cap mutual fund actually exploits volatility and enhances returns. That's what equity investment is all about!