I am shaken with my MF portfolio. My exposure to small-caps, midcaps is about 40%. How to survive the tough market conditions?

The Nifty Smallcap 250 index has decreased by almost 24% from its peak in September. The recent 24% drop has led to warnings from industry experts advising investors to halt their systematic investment plans (SIPs) and take precautionary measures. It appears that many individuals are offering advice on the timing of entering and exiting this volatile market segment. 

My current allocation to small-caps and midcaps stands at 40%. Given the significant market fluctuations, I am considering reevaluating my smallcap allocation. 

Advice by Anand K. Rathi, Co-Founder of MIRA Money.

Yes, small-cap funds have declined by over 20%. If your allocation to small and mid-cap investments exceeds 40%, you should definitely be concerned, as both large and mid-cap, as well as small and mid-cap sectors, are currently overvalued.

Ideally, your allocation shouldn't exceed 20 per cent. Since it has now reached 40 per cent and has already declined by 20 per cent, it’s essential to take action. Look for opportunities to reduce your exposure to mid-caps whenever the market rises.

Additionally, it's important to avoid placing excessive investments in small and mid-caps, even though they have shown good returns in the past. By adhering to prudent asset allocation strategies and maintaining at least 60-65% of your portfolio in large-cap stocks, you can actively rebalance your portfolio to prevent excessive allocation to small and mid-cap investments. This can provide a sense of reassurance about your financial decisions.

Dip in smallcap, mid-cap funds

According to experts, a market correction was deemed inevitable due to stock prices in certain segments significantly surpassing earnings growth in recent years. The NSE Midcap 150 index has already dropped by 22%, while the NSE Smallcap 250 index has plummeted by 26.3% from their respective peaks.

According to HDFC Securities, mid-cap stocks experienced a 14% compound annual growth rate (CAGR) in earnings over the five-year period ending in December 2024, while their stock prices saw a surge of 28%. Small-cap stocks, on the other hand, saw a 21% earnings growth with a 27% annualized return. This significant increase in valuation would only be justified if these companies continued to deliver strong earnings growth.

However, with declining profitability, overvalued stock prices have been corrected. In comparison, large-cap stocks saw an earnings growth of 15% over the same five-year period, matching their price appreciation of 15%. 
If you are feeling concerned about the recent market downturn in mid and small cap stocks, it may help to consider historical trends. According to data from FundsIndia, it is common for this segment to experience de-rating. Since January 2004, the mid- and small-cap indices have traded lower than 10% from their peak 49% and 64% of the time, respectively. In comparison, the Sensex has only traded below this threshold 34% of the time. Particularly in the case of small caps, sharper drawdowns are more frequent, with the small-cap index trading below 30% from its peak on 39% of days, compared to 10% for mid caps and just 4% for the Sensex.

In both mid- and small-cap indices, temporary declines exceeding 30% occur approximately every 8 to 10 years. The duration of these declines and subsequent recoveries varies. The shortest time from peak to trough has been one month, while the longest has been 26 months.

The key distinction lies in the recovery time frame. The mid-cap index took a maximum of 29 months, or around 2.5 years, to regain its previous peak value. In contrast, the small-cap index required over seven years, from March 2009 to July 2016, to fully recover its value.

Caution is advised for investors in mid and small-cap stocks as the road ahead looks challenging. Deeper cuts are expected if the correction prolongs.

Exercise caution if considering investing in mid and small-cap funds. If you have over-invested in small caps, it may be wise to reduce your exposure before it's too late.