Increasing your small-cap fund allocation? 6 things to check first before investing

We all want to grow our money quickly; small funds continue to attract investors with a higher risk appetite. Small-cap investing can offer high returns, but it comes with volatility, and investors need to stay disciplined in the market for at least 6-7 years. Experts emphasise that patience and a long-term approach are crucial, particularly during the annual portfolio review season.

According to a recent study by Abakkus Mutual Fund, nearly half of the small-cap stocks are currently trading well below their historical highs, offering investors a potential opportunity to make calibrated long-term allocations.

Before reading further, please note that this is just for informational purposes only and not intended to recommend any of the schemes mentioned below.

So, are you planning to increase your small-cap fund allocation? Here are key tips for you before you invest.

1. Stress test

Small caps tend to fall harder during market stress. Stress test data shows how funds or portfolios might perform under extreme market conditions. It helps investors understand risk exposure and downside scenarios. This data is becoming increasingly important for both retail investors and fund managers to make informed decisions.

The stress test data, done every 3 months, is publicly available.

"While it is not mandatory for AMCs to sell securities on pro-rate basis (i.e. sell securities in the same ratio as the portfolio composition), for the purpose of stress test it is assumed that Mutual Fund Scheme will sell the securities on pro-rata basis to ensure equal treatment to all investors of the scheme," AMFI said. ( as published on its website)

2. Check liquidity

Small-cap stocks can become illiquid during panic selling. Investors need to keep a close eye on the liquidity available in the fund they choose.

3. Valuations

"Valuations in the small-cap space are moving closer to fair value, supported by improving earnings and stronger demand, making a calibrated increase in allocation more favourable than in the past," said Kirthi Jain, Vice President, Equity at Bandhan AMC

4. Align with your time horizon

Small-cap investing is a 5–10 year journey, not a short-term trade, and using systematic investment plans (SIPs) can help manage market volatility and reduce emotional stress.

"Treat it as a 5–10 year compounding journey, not a short-term trade. For first-time investors, it is important to stay disciplined through market cycles and commit capital that won’t be needed for at least five years to ride out volatility," said  Kirthi Jain.

Despite higher volatility, the performance data presented in the Abakkus Mutual Fund report showed that small-caps have rewarded patient investors over extended periods. Since September 2016, SIP investments in the Nifty Smallcap 250 index delivered a CAGR of 17%, compared with 12% for the Nifty 50.

5. Allocation

Another common mistake is over-allocation driven by return expectations rather than risk capacity. Investors should evaluate the fund’s investment philosophy and the risk management framework implemented by the fund manager to sustainably generate returns.

According to Kirthi Jain, the following can be general guidelines that the investors can follow:

• Conservative investors: 0 – 10%

• Moderate investors: 20–30%

• Aggressive investors: 30–40%

"That said, the above allocation should apply only to the portion of the portfolio that the investor is willing to remain invested for at least five years," Jain added.

6. Market timing

Avoid chasing past returns. The rise may not last just because small-cap funds have recently produced impressive returns.

This happened during the COVID period. Following the steep decline during the COVID-19 market meltdown in early 2020, markets rapidly recovered. Many small-cap stocks in 2021 delivered very high returns, drawing in a large number of new investors. However, as the market got turbulent in 2022, individuals who had entered after the great rally experienced steep corrections. Spreading your investments over time rather than making a big one-time investment after a rise is a better option.