I never normally talk about it, but there's a huge element of excitement in equity investing. This excitement, a sort of 'thrill of the hunt' is something that drives a lot of equity investors. Over a long period, we can make a lot of money by investing steadily in a set of SIPs, but at some level, many of us have a gambling instinct, and they are driven to equity investing by it.
Many investors do not need this (I personally do not), but, as I've said earlier, there's something to be said for such investors having an allocation for 'fun money'. This is a sum of money that you invest in stocks where there might be some basis for investing but you know it's mostly a gamble. How much of your investments you risk on the fun money is up to you. I think just being aware that some investments are fun money while others are serious would keep gambling-prone investors to the straight and narrow path of limiting the fun money to something.
However, one step above 'fun money', but still not quite at the same level as steady and safe investing, is small-cap investing. This is where the thrill of the hunt is the sharpest. Who wouldn't like to have bought Eicher Motors or Ajanta Pharma or Symphony when they were small caps. In a light hearted way, I would say that this is the purest experience of equity investing. I don't mean that investing in Reliance Industries or Infosys is not equity investing. What I am saying that is that if the experience of buying a stock is to reflect owning a business and prospering with it, then the way to really experience it is to buy a small-cap and then watch it grow into a mid-cap and then a large business.
However, that's not something that's meant for most mutual fund investors. If small-cap equity investing is to be done sensibly, rather than as a gamble, then a regular investor should do it through small-cap funds.
Over the last decade or so, a well chosen small-cap fund would have given you the most profitable investment experience. However, 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. Equity investing seems like the easiest thing in 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.
When that happens, what should investors do? Should they quit and run (perhaps switching their investments to large-cap funds), or should they stick it out? For some investors, if they feel they can't take 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: diversification. And the second principle, no less important, is to understand that volatility is actually your friend if you are investing in small- caps through mutual funds.
SIP investing and small-cap funds are well-suited for handsome returns. SIPs are basically a way of exploiting volatility to increase your returns and small-cap funds are more volatile than other types of equity funds. It's a match made in heaven.