What is the right market-cap mix?

In our previous story, we discussed the various investing styles. Here we will talk about how to think about companies of various sizes.

Different sizes have different growth prospects. So, let's dive into each of the categories to understand more.

Large caps
When it comes to large-cap companies, growth is likely to be moderate. If that is not the case, then growth would already be priced in. To invest in such companies, you have to wait for them to stumble.

Many large caps keep chugging along, with ITC being a perfect example. For all its monopoly and cash flows, the company has returned about 6 per cent per annum in the last 10 years. Clearly, its size hasn't been of any help in rewarding its shareholders.

Also, the risk aspect of this category cannot be overlooked. There have been many large-cap companies that have been consigned to oblivion. Remember Suzlon, Jaiprakash Associates and YES Bank.

Mid caps
This category offers a good balance between growth and stability. To reach the mid-cap stage, companies need to prove their mettle extensively.

You need sharp analytical skills to distinguish between good and bad prospects. It is not as if these companies are hidden. Mid-cap companies are known to many investors. But they still have ample room to grow. You have to figure out their growth prospects.

Many investors assume that after a period of high growth, the company wouldn't be able to grow any further. But such thinking can take a toll on your portfolio. It is not easy to replace high-quality growth companies. So, just strengthen your research and have the temperament to deal with the various short-term problems market throws.

Small caps
This category offers hope to many investors but only a few find anything tangible. To succeed in the small-cap universe, you need to be knowledgeable and gain the expertise to think independently. You also need to invest with a long horizon.

A great deal of perseverance is also required to hold on to these companies through thick and thin. As mentioned previously, high-quality growth is not easily replaceable. There will always be phases of overvaluation and undervaluation. So, develop the mental fortitude to deal with it.

In the last 10 years, BSE 100, BSE MidCap and BSE SmallCap have returned 12.8 per cent, 14.5 per cent and 15 per cent per annum, respectively. These higher returns for small companies come with higher volatility. BSE 100, BSE MidCap and BSE SmallCap have witnessed monthly volatility of 4.8 per cent, 5.8 per cent and 6.7 per cent, respectively.

Micro caps
These are the companies with small operations and negligible coverage by institutional investors. As a result, the greatest reward comes when a company is 'discovered' by some institutional investors.

With little to no transparency, minimal information and a lack of a track record, there is very little scope for research on these companies. Exceptional analytical skills, a lot of groundwork and temperament to spare are needed. This makes this category the riskiest and the most rewarding one.

Identifying one or two such companies is more than enough. Invest with at least a 10-year horizon.

What's the right mix?
A balanced allocation of (say) 40-50 per cent large caps, 30-40 per cent mid caps and the remaining in small and micro caps should bode well for most investors. Get into small/micro caps only if you have nerves of steel and can do extensive research.

Also in the series:
How many stocks should you own?
Which investing style is the best?