Understanding the Risks of Investing in Smallcap Stocks
Recently, many investors have been captivated by the surge in smallcap stocks, leading them to believe that every smallcap investment could potentially transform into a multi-bagger. However, this optimism may be misplaced, as the current market cycle exhibits signs of survivorship bias. Survivorship bias occurs when investors focus solely on the success stories while disregarding past failures, thus distorting the true landscape of investment opportunities.
Survivorship Bias and Historical Data
Mihir Vora, Chief Investment Officer at Trust Mutual Fund, has shared enlightening data that sheds light on this issue. In 2014, there were 100 largecap stocks, of which:
- 17 transitioned into midcap stocks
- 4 fell into small cap category
- 1 stock even slipped into microcap status
This statistic poses a significant question: how many investors could have found themselves invested in a largecap stock that eventually became a microcap? This exemplifies the inherent risks associated with largecap stocks, challenging the notion that they are the safest investment choice.
The Smallcap Stock Landscape
In 2014, 250 smallcap stocks were identified. Of those:
- Only 3 managed to ascend to the largecap category
- 43 progressed to midcap status
- 93 stocks deteriorated to microcap status
Fast forward to today, and the smallcap landscape remains populated with 250 stocks, yet only 4 of these have reached largecap status, and 35 evolved into midcap stocks. Notably, 99 microcap stocks from the earlier classification have now gained smallcap status. This data highlights the duality of investment success and failure, painting a more comprehensive picture of the stock market’s dynamics.
The Insights of Prashant Jain
Another expert, Prashant Jain, shared similar sentiments during his departure from HDFC Mutual Fund, where he served as Chief Investment Officer. Between October 2003 and July 2022, he managed three funds and invested in 465 stocks. His findings were telling: one in four of these stocks resulted in losses, totaling 113 losing stocks, with 110 of those falling into the bottom two categories. Each of these stocks incurred losses amounting to Rs 250 crore. However, one successful investment negated the losses from all other failing stocks combined. Jain’s journey emphasizes that even seasoned investors face failures in their portfolios, a reality often overlooked by the general public.
Lessons from the Past
Many people often wonder why their parents never ventured into the stock market. They speculate that if their parents had invested, they might have amassed considerable wealth. However, it’s crucial to consider the alternative scenario: what if those investments were in underperforming stocks such as DSQ Software, Silverline Technologies, NEPC Micon, Scindia Steamships, and Hindustan Motors? In contrast, investments in established companies like HUL, HDFC, RIL, SBI, ITC, Nestle, Gillette India, and 3M typically provided greater financial security. These historical references reveal the inherent risks of investing without thorough research and highlight the necessity of understanding stock market dynamics.
Conclusion: A Balanced Perspective on Investing
Investing in smallcap stocks can be enticing, yet it is essential to recognize the associated risks, particularly the existence of survivorship bias. By understanding historical trends and being mindful of both success and failure, investors can make more informed decisions. Cultivating a balanced perspective is crucial in navigating the complexities of the stock market, ultimately leading to more strategic investing and better outcomes.
