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Investors riding the small-cap tiger's back

Are you ready for the end of the ride?

Navigating small-cap investment risks: Strategies and outcomesAnand Kumar

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A few days back, I had an interesting conversation with a senior mutual fund executive who has held a wide variety of investment management positions in the industry for more than two decades. As is inevitable nowadays, the discussion on equity investing turned inevitably towards small-caps. Like most sensible observers, my friend agrees that small caps are out on a limb. Not all of them, but many - perhaps most.

Stock prices have run up to levels that are hard to justify, and there will be a reckoning at some point. Nothing unusual about this - this is completely normal in small-cap investing. Every single time there's a sharp run-up, it ends in a sharp descent. On the whole, things worked out, but only for those investors who chose their stocks well and managed other aspects like cost-averaging, diversification and asset allocation well. Those who follow the herd get herded out sooner or later. This is the way it is.

Unfortunately, as my friend confessed, equity mutual fund managers find it impossible to avoid small-cap booms. This is because, in the quest for outsized returns, small caps present an irresistible allure. Their potential for rapid growth and substantial gains is unmatched in the short term, despite the high volatility and risk. Fund managers, under the pressure to perform and deliver above-average returns to their investors, often feel compelled to participate in these rallies, even knowing the risks involved. This participation is not just about their pursuit of performance but also reflects the intense competition within the mutual fund industry, where standing out often means taking on more risk. Staying out of any rally means underperformance compared to peers, and, as I was told, money starts flowing out. Of course, a savvy fund manager should be able to navigate these waters, but basically, during small-cap booms, everyone is riding a tiger's back.

An individual investor with a proper long-term perspective is able to avoid these problems. However, the crazy thing is that many investors also manage to get on to the back of the same tiger simply out of a misplaced sense of aggression. This creates a dangerous feedback loop, as their demand inflates prices further, enticing even more players into the game. The tiger gets progressively more agitated, and the eventual fall risks turning into a stampede, leaving everyone clawing for the exits. So, while individual investors hold the power to avoid the herd mentality, the pervasive narrative of small-cap boom times can be an insidious trap, tempting even the most disciplined to gamble on the tiger's volatile back.

The aggression often stems from the fear of missing out (FOMO) on potential high returns that small-caps can offer during their boom phases. Individual investors, witnessing the rapid gains made by the indexes and some mutual funds, jump into the fray, hoping to capitalise on these movements without fully understanding the risks involved. This herd mentality can worsen the volatility in small-cap markets, leading to inflated valuations and, ultimately, significant corrections. The irony is that while attempting to maximise short-term gains; these investors expose themselves to the very volatility and downturns they seek to profit from. The key to success in such turbulent markets lies in disciplined investing strategies, such as thorough research, patience, and a focus on fundamental value rather than speculative growth. For individual investors, the lesson is clear: while the allure of quick gains is tempting, the virtues of patience, research, and a well-thought-out investment strategy cannot be overstated.

But what about the fund managers who chase performance? I'm afraid this is one of those situations where investors' short-termism and the business reality of running open-ended funds create a minefield that's hard to navigate. Ultimately, the key for all investors lies in striking a balance between pursuing attractive short-term opportunities and maintaining a steadfast focus on long-term investment principles. There's nothing 'small-cap' about such an approach - it's something that investors should always be following anyway.

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