The basic tenets of portfolio diversification suggest that the key to building a diversified portfolio is to spread your investments across multiple asset classes.
While this is entirely accurate, one must understand that spreading investments across various asset classes is just the first step towards building a diversified portfolio. Even once the asset allocations have been made, investors must look to diversify within the select asset class.
Equity markets offer investors various opportunities to invest as per their goals, investment time horizon and risk appetite. These opportunities come in many shapes and sizes, which makes the size of the company an important factor to consider while making equity investments.
Diversifying your equity portfolio on the basis of market capitalisationIn equity market parlance, the size of a company is synonymous with its market capitalisation.
According to new Securities Exchange Board of India (Sebi) guidelines, the top 100 companies in terms of market capitalisation are categorised as large-cap companies. The next 150 companies are categorised as mid-cap companies and the 251st company and below are categorised as small-cap companies. It is important to be cognizant of this because investing in a company of a certain size brings with it unique opportunities and risks.
The advantages and drawbacks of large-cap investments are different from that of small & mid-cap investments. Consequently, the value that each of these investments add to a portfolio is differentiated and unique.Large-cap stocks are basically shares of well established companies that have a strong market presence and are considered as leaders in their fields. These companies have generally been operating for an extended period of time and have witnessed multiple market cycles.
Over the years, they have been able to survive, as well as, thrive through the ups and downs of the macro-economic landscape. The biggest advantage of large cap companies is that they are relatively stable compared to their mid and small cap counterparts.
However, since these stocks are mostly on top of their game, they provide little or no opportunity for aggressive growth. Share price appreciation prospects for large-cap stocks are limited considering that they are past their aggressive growth years.
Thus, the inclusion of large caps in your portfolio will likely reduce the overall portfolio risk but is unlikely to significantly enhance portfolio returns. Mid & Small cap stocks are shares of companies which are up and coming and are at different stages of their growth cycle. These are companies that are creating new businesses across the investment spectrum and are at different phases of growth. The expectation is that many of these companies will at some point in the future witness aggressive growth and thus provide investors with a greater return potential. However, this higher return potential comes with higher risk.
Since these companies are still growing, there is a greater degree of volatility in their operating performance which is reflected in their share prices as well. Thus, the inclusion of mid & small caps in your portfolio can substantially increase the return potential but it also increases the overall portfolio risk.A long term investment horizon helps investors absorb higher volatility and reap the return potential of their investments. A disciplined and consistent investment philosophy is integral to generating optimal returns.