Small Cap Funds: What You Need to Know About Volatility

Introduction

In the investing world, funds that generate high returns catch the eye of the investors. Those looking for great growth potential might find a profitable opportunity by investing in Small Cap Mutual Funds. However, smaller funds are often more volatile than large-cap funds, resulting in big price fluctuations and uncertainty. Understanding the nature of this volatility, its beginnings and impacts on investors to make informed investment choices.

In this article, we will explore the subject of small-cap funds and the potential risks associated with them. We will provide you with helpful techniques that will enable you to manage these risks effectively. So, sit back and relax as we take you on a journey of discovery and prepare with the tools you need to make informed investment decisions.

Understanding Small Cap Funds

Being the first runner-up in its category, Bandhan Small Cap MF has established a strong reputation for itself in the investment community. With assets under management (AUM) of Rs.4384.9 crores as of March 31, 2024, it has produced an outstanding 37.32% return since its founding. Investors who are prepared to assume a greater degree of risk in exchange for the possibility of substantial gains are the target market for the Bandhan Small Cap stock. The fund invests in start-ups and lower market capitalisation businesses with strong development potential as it focuses on small-cap firms. This implies that compared to larger, more established funds, the equities in this portfolio may be more volatile.

Nonetheless, this fund can be a great option if you can afford this degree of risk and are searching for a fund that might yield substantial profits. It's crucial to remember that small-cap stock investing may be unexpected, so you should always conduct research before investing.

What does Volatility Mean in Small Cap Funds?

• Volatility in small cap funds represents how frequently and significantly the underlying stocks' prices fluctuate over time. 
• Unlike large-cap stocks, which usually have stable earnings, an established market presence, and a broader investor following. 
• Small-cap stocks tend to experience more dramatic shifts in value. Several factors can trigger these fluctuations. 
• For example, changes in market sentiment can drive investors to buy or sell in large volumes, creating rapid price swings. 
• Economic conditions also play a role, as broader trends can impact corporate performance and investor confidence. 
• Company-specific events like earnings reports, leadership changes, new launches can cause sudden spikes or drops in stock prices. 
• Small Cap Mutual Funds have lower liquidity and a rise in trading activity can lead to even larger price swings.
• Although this volatility creates opportunities for high returns, it also increases the risk of sudden and significant losses.
• It requires investors to stay aware of these dynamics and be ready to manage the associated risks.

Sources of Volatility in Small Cap Funds

Several key factors that resulted in the rise in market volatility of small cap funds are as follows:

Limited Resources

Small-cap companies often operate with fewer resources compared to larger firms. This limited capacity can increase their vulnerability to disruptions caused by supply chain issues, competitive pressures, or financial constraints. As a result, when these companies face challenges, their stock prices often react with significant volatility.

Lower Liquidity

Small-cap stocks generally have lower liquidity than large-cap stocks, which means they experience less trading activity. This lower volume can lead to more pronounced price swings, especially when there's a rise in trading activity or during times of economic uncertainty.

Economic Sensitivity

Small-cap companies tend to react more strongly to shifts in the economy. During economic downturns or recessions, these companies may struggle financially, causing their stock prices to fluctuate more dramatically than those of larger, more stable companies.

Imaginative Nature

Investors frequently perceive small-cap companies as more speculative due to their potential for rapid growth and less established business models. This perception can drive significant price fluctuations based on market sentiment, rumours, or news events, contributing to the increased volatility of small-cap funds.

Impacts of Volatility on Investors

Let's explore each of these points in more detail to understand the effects of volatility in small cap funds on investors:

Increased Risk

• Small-cap funds are riskier than large-cap funds because they invest in smaller companies that are often in earlier stages of growth.
• These companies typically have fewer resources, less stable revenue streams, and lower liquidity in their stock. 
• Consequently, they are more susceptible to market fluctuations, economic downturns, or industry-specific risks.
• The higher volatility in these funds can lead to rapid gains when markets are favourable, but equally rapid losses when conditions change. 
• This heightened risk means that investors in small-cap funds must be prepared for significant price fluctuations and potential losses.

Emotional Impact

• Investors in small cap funds often experience a higher level of emotional stress due to the volatility in these investments. 
• The frequent and sometimes dramatic price swings can trigger fear, anxiety, or even euphoria, depending on market conditions. 
• This emotional rollercoaster can lead investors to make impulsive decisions, like panic-selling during a downturn or over-investing during a rally, potentially undermining their long-term investment goals. 
• Managing emotions and maintaining discipline becomes crucial for investors in small-cap funds to avoid making rash decisions that could harm their returns.

Potential for Higher Returns

• Despite the increased risk and emotional stress, small-cap funds can offer substantial returns over time. 
• The smaller companies that these funds invest in often have greater growth potential, allowing for significant capital appreciation as the companies expand and mature. 
• Investors who are willing to take on the added risk and can maintain a long-term perspective might find these funds attractive. 
• However, achieving these higher returns often requires patience, discipline, and a solid investment strategy that accounts for volatility and the associated risks. 
• Long-term investors who understand the potential ups and downs in small-cap funds can have significant rewards.
• If they remain committed and avoid making impulsive decisions based on market fluctuations.

Strategies to Decrease Volatility Risk

Investors can use several strategies to mitigate the volatility risks associated with small-cap funds:

Diversification

Investors can reduce the impact of Small Cap Mutual Funds volatility by diversifying their portfolios across different asset classes, sectors, and geographic regions. This approach creates a more balanced portfolio that can better endure market fluctuations.

Long-Term Investment Horizon

By adopting a long-term perspective, investors can counter short-term volatility in small cap funds. The growth potential of these companies often outweighs price swings when viewed over an extended period.

Rupee -Cost Averaging

Rupee-cost averaging involves investing a set amount at regular intervals, irrespective of market conditions. This strategy helps investors manage volatility by purchasing more shares when prices are low and fewer shares when prices are high.

Thorough Research and Due Diligence

Before investing in small-cap funds, investors should conduct thorough research to understand the fund's management style, investment philosophy, and underlying assets. This due diligence ensures that the chosen funds align with the investor's risk tolerance and investment objectives.

Conclusion

In conclusion, investments made into this fund scheme via SIP will help investors build long-term wealth. Looking to invest for 5-7 years then this is the best option for making high returns. Make sure that the investments and one’s financial goals match with each other.