Be a real investor

Over the years, I've always tried to remind my readers to pay attention to two basic facts about investing. Equity investing (including equity mutual funds) is like owning a business, and fixed-income investing is like lending to a company. These are basic, self-evident ideas, but how often we lose sight of them is surprising. Understanding these fundamental principles can significantly impact your attitude toward your investments. When you invest in equities, you become a part-owner of the companies you invest in, which means your returns are tied to their success or failure. However, most of the time, it does not feel like that because you are just buying and selling shares.

Let me take this concept a little further. Only small-cap investing is real equity investing. Of course, my saying that only small-cap investing constitutes real stock investing may be provocative, intended more to captivate attention than convey an absolute truth. While I typically avoid making such bold statements, I hold this belief true. I'm not suggesting that purchasing stocks like Infosys or HDFC Bank isn't a form of equity investing because it certainly is.

I'm emphasising that if the goal is to replicate the experience of owning a business and witnessing its growth, one must consider investing in small-cap stocks. By doing so, you can experience their evolution into mid-cap and ultimately, large-cap businesses, thus truly immersing yourself in the essence of equity investing. That's what a real business owner does. Business ownership is all about the gains (and the satisfaction) from starting a small business and then watching it grow into something big and substantial. And if you think that sounds a bit emotional and over-the-top, that's because I speak as an investment advisor and magazine editor and as someone who started and grew a business.

Small-cap stocks and mutual funds that focus on them have recently made great gains for investors. As you will read in our cover story of this issue, 'Small-cap funds', investors have allocated increasing amounts of money into funds focused on smaller companies. These investors have been rewarded with strong returns from small-cap funds. However, this enormous money flow has also changed the small-cap investing landscape. For one, small-caps are small, meaning each stock can only absorb a small amount of investment compared to larger companies. This has stretched fund managers and led to a broader variation in fund performance and, most importantly, risks. It is inevitable as the underlying stocks have a much wider quality variation than larger ones. All this adds up to quite a challenge for fund managers.

This challenge is then inherited by investors - in the form of a wider variation in fund performance and by us, who are here to serve you with analysis and guidance!

I firmly believe in the role played by each investor's mindset in whether and how much money they make. With small caps, that role is magnified simply because of the volatility.

While small-cap investing has provided substantial returns recently, realising these returns over the long run requires stomaching inherent volatility. When performance is strong, confidence runs high, and market risks can seem trivial - equity investing may appear simple, and volatility warnings seem overblown. However, markets fluctuate, and risk tolerances rightly shift when declines hit, and portfolio values drop daily. Investors must ground themselves in realistic volatility expectations rather than extrapolating recent returns to stay invested in small caps and capture their long-term potential.

Embracing volatility is easier said than done, so maintaining perspective around the fundamentals of this segment's risk-return profile is key. It helps investors stick to small-cap allocations when downward spells inevitably emerge.

Being a real investor isn't easy, but the rewards are enormous, and we are here to help you.

Also read: Panic and sudden meltdowns