Why discipline and diversification are more effective than trying to time the market for long-term investors

The darlings of Dalal Street—small- and mid-cap funds—are now undergoing a reality check. After two years of stellar gains, volatility has crept in, and the correction has eroded the short-term euphoria. However, history often suggests that those who ride the dips often create the most wealth over time.

Early Advantage

Experts say small- and mid-caps typically have lower institutional ownership, allowing fund managers to enter early before valuations catch up. “This helps ride the full growth curve as these companies mature into large caps,says Abhishek Tiwari, CEO, PGIM India Asset Management.

Take this into consideration. In June 2021, the 250th largest company had a market cap of Rs 11,819 crore. As of June 2025, the figure stands at Rs 30,756 crore, per AMFI categorisation. Similarly, in the mid-cap space, beyond the top 100 companies, the 101st company had a market share of Rs 36,954 crore (June 2021). The 101st company is now at Rs 90,907 crore market cap (June 2025).

With an active primary market, we are seeing a lot more companies entering this space. They operate in niche sectors or sunrise industries like fintech, recycling, waste management, renewables, defence, and digital services. They have agile business models that allow them to scale up rapidly.

Small caps offer higher upside potential by virtue of being less saturated than large caps. Mid- and small-cap segments have consistently demonstrated their potential for long-term wealth creation. “While these segments inherently carry higher volatility compared to large caps, they also offer differentiated growth opportunities that can significantly enhance portfolio outcomes over a 7- to 10-year horizon,” says Tiwari.

Volatility Test

Mid- and small-cap funds delivered stellar returns through 2023 and early 2024, driven by strong earnings growth, a resilient domestic economy, and retail participation. After two years of phenomenal performance, returns over the last year or so have moved into the negative territory.

As we know, markets are never unidirectional—they move through cycles and periods of volatility. History shows that even after major crises like the global financial meltdown or the Covid-19 pandemic, markets rebounded strongly. However, the greatest risk investors often face isn’t market risk, but emotional risk.

“Mid- and small-cap funds, by nature, are best suited for long-term investors. While they offer high growth potential, they also come with higher volatility. Staying invested through cycles helps capture long-term gains,” says Shreyash Devalkar, Head—Equity, Axis Mutual Fund.

In the risk-reward matrix across the cap curve, large caps are typically at the lower end of the risk-return trade-off, and it rises as we move towards mid and small caps, which tend to be riskier asset classes and more volatile. If you look at small- and mid-cap funds, they will fall under the ‘very high’ risk category.

“As a result, longer-tenured money and risk awareness for certain speed bumps along the way are desirable,” says Jitendra Sriram, Senior Fund Manager—Equity at Baroda BNP Paribas Mutual Fund.

Ultimately, short-term corrections should be viewed as part of the market cycle, not as a trigger for panic exits, and can be an opportunity to allocate more basis to one’s asset allocation. “For long-term investors, discipline, diversification, and alignment with financial goals remain far more effective than trying to time the market,” says Sirshendu Basu, Head, Products, Bandhan AMC.

What works better is starting with your financial goals and risk profile rather than reacting to short-term market movements. Trying to time the market is rarely effective, especially in mid- and small-cap segments, where volatility is a natural part of the journey.

If your investment was linked to a specific goal, the ideal exit point is when that goal is approaching, not when markets appear uncertain.

“The key is to stay goal-driven, not emotion-driven. Exiting due to temporary market dips often means missing the rebound that typically follows,” says Amit Suri, Mutual fund distributor & founder of AUM Wealth, financial distribution organisations.

Risk Management

Fund managers adopt several risk management strategies to mitigate risks in small- and mid-cap funds while aiming for growth. Typically, they balance risk by diversifying across sectors, maintaining liquidity thresholds, and focussing on quality businesses with strong balance sheets to protect capital during downturns.

First, they spread investments across multiple companies and sectors to avoid overexposure to any single stock or industry. “The other tools that are used could be 1. Moving to the higher end of market caps to the extent of permitted leeway 2. Sector shuffling from high beta sectors (eg. construction, industrials, etc.) to lower beta sectors (moving from highly leveraged companies to low leverage companies can be a method to cut financial leverage risks) 3. Reducing concentration risks in the portfolio and lastly minor increases to cash levels as well,” says Sriram.

For example, in Bandhan Small Cap Fund, fund managers typically maintain around 20% allocation to cash and large-cap stocks, which helps in enhancing liquidity and reducing volatility.

The way to approach small- and mid-cap funds would be to assign a portion of portfolio to risk assets where one is able to carve out a certain section where the investor is able to tolerate a higher risk-return trade-off and has no immediate need for that money.

“These can then be earmarked for alpha creation in the long run. SIP is a better choice for a salaried individual wanting to commit a certain sum each month to smoothen out market volatilities, while a lump sum may be better for someone realigning the portfolio to build in a certain risk in the quest for better returns,” says Sriram.

Mid- and small-cap funds can thus play a crucial role in a long-term wealth creation strategy for retail investors, particularly when approached with discipline and the right allocation strategy. However, these categories should be viewed as satellite allocations, complementing core holdings in large-cap or diversified funds.

“Typically, 15–25% of the equity portfolio can be allocated to mid and small-cap funds, depending on the investor’s risk appetite and investment horizon,” says Basu.

For systematic investment plan (SIP) investors, these funds are particularly effective. Regular monthly investments help average out costs across market cycles.

In fact, Basu says, analysis of rolling returns data shows that if an investor had remained invested in mid and small-cap indices for over seven years, they would have never encountered negative returns.

Therefore, investors should remain calm during bear markets and adhere to a disciplined rebalancing strategy. Time in the market and not timing the market can lead to greater wealth creation.

Investment Clarity

When selecting funds, it is imperative to move beyond headline returns/recent one-year performance. Metrics such as information ratio and downside capture provide deeper insights into a fund’s ability to generate risk-adjusted returns and protect capital during drawdowns.

“Additionally, rolling return analysis offers a more robust view of performance consistency and volatility across market cycles, as opposed to point-to-point returns, which can be misleading,” says Tiwari.

Apart from performance data, Sebi has mandated disclosure of various parameters for investors to make informed decisions, which are as follows:

 Stress Test Data: “Stress test liquidity data equips investors with practical insights into how easily and quickly their investment can be converted to cash under stressed market conditions,” says Basu.

So, the idea is to measure how quickly these funds can convert their assets into cash under stressed market conditions, such as when 25% or 50% of investors demand redemptions simultaneously. The stress test data needs to be published monthly. Sebi mandates these tests to make sure that fund houses have enough liquidity and can meet investor redemption requests without significant price impact.

 Investor Concentration: This data highlights how reliant a fund is on its largest investors.

 Market cap segmentation: This data provides insights into the fund’s allocation across different market capitalisations—large cap, mid cap, small cap, and cash.

Volatility Data: “This data shows the fund’s and benchmark’s annualised volatility (standard deviation) and beta, indicating that higher values reflect greater portfolio risk,” says Basu.

Valuation Data: This data shows the price-to-earnings ratio of the fund and its benchmark along with the portfolio turnover ratio, helping assess whether a fund is overvalued or undervalued.

Smart Rebalancing

As we have seen, small- and mid-cap funds tend to outperform during market rallies but often lag large-cap funds during periods of consolidation or decline—such as the current phase. Investors can use these cycles as opportunities to rebalance their portfolios, shifting selectively from mid- and small-cap or thematic funds toward large-cap allocations.

“However, it’s important to remain invested across market cycles. Any rebalancing should be measured and partial, not a complete exit from these segments,” says Devalkar. Rebalancing isn’t something that should be done only for a specific mutual fund category. It’s about examining the overall portfolio and evaluating how each component aligns with your goals and risk tolerance.

Certain life events, such as the birth of a child, retirement, or any change that reduces your risk-taking capacity, can be natural triggers to reduce exposure to higher-risk categories.

In the end, small- and mid-cap funds are not for the faint-hearted—but those who stay the course, can be deeply rewarded. By maintaining discipline, smart diversification, and aligning investments with clear financial goals, investors can turn short-term market corrections into opportunities.