Should you set up an SWP in a small-cap fund?

If we build a small-cap-heavy portfolio, how do we transition to a lower volatility portfolio that is suitable for setting up an SWP? Alternatively, can we set up an SWP on a small-cap fund with a high corpus? - Hariharan Ananthanarayanan

Small-cap investments are risky. I tried to simulate your situation to illustrate this. Suppose someone had Rs 1 crore in a small-cap fund and withdrew 10 per cent of it annually since 2006. Despite these withdrawals, the investment would still grow to ₹6.3 crore. This shows how high the returns from small-cap funds can be. However, I'm not suggesting withdrawing 10 per cent annually; in fact, I usually recommend being more conservative in the initial years.

Suggested read: SWP: Finding the ideal equity allocation

Now, consider a scenario where the same Rs 1 crore investment had a withdrawal rate of only 2 per cent annually. In that case, the investment would grow to Rs 18.7 crore. My suggestion is this: if you have a substantial asset base and a sizable portion invested in small caps, and your withdrawal rate is under 3 per cent, you can keep your investment in small caps. Moreover, this approach allows you to remain calm and avoid losing sleep during market downturns.

Over the next 20-30 years, you are likely to experience two or three major market crashes, like the one in 2008. During these times, markets will crumble, and small caps will fall even more significantly. However, if you're withdrawing only 2 per cent annually, you'll be able to endure these declines without losing sleep. Confidence and prior experience with such market cycles are key to sticking with your investment strategy. This ability to "stick around" is critical for long-term success and is built on understanding how markets work and experiencing their ups and downs.

Let me provide another example. If you invested in an equity savings fund - a very conservative investment vehicle - and started withdrawing 4 per cent annually during retirement, your investment (assuming it began in 2005) would grow to Rs 1.73 crore. However, if you invested in a small-cap fund and withdrew the same 4 per cent annually, your investment would grow to Rs 15.6 crore. These returns are undeniably tempting.

The key is to get accustomed to the volatility of small caps. If you can handle the fluctuations, small-cap investments can be incredibly rewarding. However, if you find it challenging to tolerate such volatility, you should consider more conservative investment vehicles.

Conclusion

This question was asked by a subscriber, and featured on our special series Subscribers' Helpline. If you'd like to get answers to similar questions, watch last month's episode.

Also read: What is an SWP in a mutual fund?

This article was originally published on December 05, 2024.