Table of Contents
Smallcap returns of 17% over five years feel like a free lunch. They’re not. The behavioural and valuation reasons to think harder about your smallcap allocation are uncomfortable but worth understanding.
The seductive math of smallcap returns
Indian smallcap indices have averaged 17% annually over the last 5 years. Some specific funds have done 20%+. By comparison, large-caps did 12% and mid-caps did 15%. The headline numbers make the case for tilting toward small.
But headline returns hide the experience.
Smallcaps got crushed in 2018, falling 40%. They recovered in 2019, then fell 30% in March 2020. They surged through 2021. Corrected sharply in 2022. Surged again from late 2022 through 2025. The 17% average is real. The journey to it is brutal.
Most retail investors enter smallcaps after the surge. They buy the headline returns. They get the next correction at full intensity. By the time they recover, they’ve often abandoned the strategy and moved to large-caps just before the next smallcap rally.
What drawdowns actually look like
Smallcap drawdowns of 30 to 40% within a 12-month period are not rare. They’ve happened multiple times in the last decade.
The recovery time after a 35% smallcap drawdown is typically 2 to 4 years. During that time, you watch your investment underperform other categories, and the temptation to switch is enormous.
If you can’t sit through 35% drops without acting, smallcap exposure isn’t right for you. Don’t fight your psychology. Adjust the allocation.
Liquidity risk that doesn’t show up daily
Smallcap stocks have lower trading volumes. In normal markets, this is invisible. In stressed markets, it matters.
When everyone wants to sell, smallcap fund redemptions can force the manager to sell at unfavorable prices. The NAV drop in panicky markets can be sharper than the underlying price decline because of liquidity premium widening.
This is why smallcap funds underperformed in 2018 and 2020 corrections beyond what the indices suggested. The liquidity adjustment hits at the worst possible time.
Mid-caps have similar but milder issues. Large-caps are highly liquid and don’t face this.
When mid-caps offer the better trade
For most HENRY portfolios, mid-caps are the sweet spot.
Mid-cap returns have been close to smallcap returns over long periods (15% vs 17%) with meaningfully lower drawdowns (typical max drawdown of 25 to 30% vs 40 to 50% for smallcap).
Mid-cap stocks have better analyst coverage, better governance disclosures, and generally more mature business models. The information asymmetry is less brutal than in smallcaps.
For investors wanting growth above large-cap returns but with manageable risk, mid-cap is the cleaner choice.
The right allocation for your stage
Allocation guidelines that match risk tolerance and time horizon.
Aggressive HENRY in 30s with 25+ year horizon. 30 to 40% mid-cap, 10 to 15% smallcap, rest large-cap and international.
Moderate HENRY in 30s. 25 to 30% mid-cap, 5 to 10% smallcap, rest more conservative.
Conservative HENRY in 40s. 15 to 20% mid-cap, 0 to 5% smallcap. The volatility just isn’t worth it for shorter horizons.
The biggest mistake retail investors make is sizing smallcap based on recent returns. After good years, allocations creep up. After bad years, they get cut.
A consistent allocation, sized to what you can actually hold through drawdowns, beats a tactical approach that gets the timing wrong.
How to add smallcap if you don’t have it.
Don’t lump in. Smallcap valuations after the 2024 to 2025 rally are not cheap. Average P/E of the smallcap index is at the higher end of historical ranges.
Phase in over 12 to 18 months. Use SIPs. Be patient. The next smallcap entry point may come from the next correction, not the current setup.
Pick funds with managers who have navigated multiple smallcap cycles. The dispersion among smallcap funds is wider than in any other category. Top quartile vs bottom quartile can be 6 to 8% per year.
If you don’t have a high-conviction smallcap manager you trust, an index fund or ETF (Nifty Smallcap 250) is acceptable but accept that you’re getting average rather than skilled selection.
The honest truth about smallcaps.
They reward patient capital generously. They punish impatient capital severely. The entry point matters more than in any other category. The exit discipline matters even more.
Most retail HENRYs would do better with 5 to 10% smallcap allocation than 20%. Less is often more in this category. The compounding from a small, well-held position is greater than the compounding from a larger, badly held one.
Smallcap isn’t a free lunch. It’s a paid premium for sitting through pain that most investors aren’t psychologically equipped for. Be honest about whether you are.
