Introduction to Long-Term Investing

Greetings. Are you considering a long-term investment horizon of 20-25 years and wondering if small cap investments are the right choice? This article aims to provide you with insights into the world of small caps and how to create a balanced investment portfolio to meet your financial goals.

Understanding Small Cap Funds

Small cap funds themselves are quite diversified. With many small cap funds holding investments in over 200 companies, it’s not necessary to spread your risk across multiple small cap funds to maintain diversity. By investing in one small cap fund directly, you are essentially investing in 200 companies, not more than 2 per company. If you were to add another small cap fund with no overlapping companies, you would be investing in 350 to 400 companies. However, this may be redundant and not the most prudent strategy. Alternative options such as a single index fund, export-oriented sector scheme (ELSS) fund, or a flexible cap fund paired with a small cap fund might serve you better.

Why Not 100% in Small Caps?

Investing 100% of your portfolio in small-cap stocks can be incredibly risky, even for those deeply interested in small cap investments. While small cap stocks can offer significant returns in a short time, they are also highly volatile and can correct drastically during market downturns. Instead of allocating 100% or even 20 small cap stocks to your investment portfolio, consider a more balanced approach.

For a long-term investment horizon, you might consider the following allocation strategy:

This balanced approach reduces the risk of losing all your gains in one market downturn. If you are completely focused on small-cap stocks, you might find yourself in a 0 or 100 situation, with little room for recovery if the stocks do not perform well.

Timing and Market Considerations

Small cap stocks are known for their volatility, especially during bear markets. If you are investing for a long period such as 20-25 years, it’s crucial to ensure that you won’t panic if the portfolio remains in the red for a prolonged period. Additionally, you should closely monitor the markets as you approach the end of your investment horizon.

The risk of a market downturn eroding all your gains in one fell swoop is significant. For instance, in 15 months starting from January 2008, small caps fell by 70-80%, wiping out 10 years of returns. This scenario underscores the importance of not having a single category exposure, regardless of your investment horizon.

Conclusion and Next Steps

For those committed to long-term investments, small cap funds can be a valuable addition to your portfolio. However, it’s essential to diversify your investments to manage risk effectively. By carefully considering the allocation of your funds, you can ensure a more stable and secure investment journey.

To learn more about personal finance and investment strategies, follow us on ET Money.