Small caps sink, midcaps wobble: What should investors do in this rough market?

India's small- and mid-cap segments are enduring a sharp correction in 2025, prompting investors to reassess strategies amid heightened volatility and FII outflows. The BSE Smallcap index has plunged 9.45% year-to-date, marking its poorest showing since 2018's 23% crash and reversing a spectacular 93% rally across 2023-24 that fueled retail frenzy and record fund flows.

This downturn stems from overvaluation pressures, disappointing Q3 FY25 earnings, geopolitical tensions, and a record $9 billion FII sell-off in January alone, which weakened the rupee and eroded confidence in riskier assets. While Nifty holds modest gains, small caps' deeper pain—exacerbated by liquidity tightening and muted domestic growth—raises doubts about a swift 2026 rebound, with analysts eyeing prolonged consolidation.

Alok Jain, Founder of Weekend Investing, explained the severity of the decline: “Small caps are certainly bleeding right now. While the fall has been ongoing for over a year, the drop since November has been brutal. The index has broken down below the 16,500 support level, with potential targets as low as 15,000 or below. The pain felt at the individual stock level is even worse than what the index reflects.”

Comparing market segments over the past year shows stark differences. The Nifty index remained 5% positive, midcaps gained 7%, but small caps dropped 12%, and microcaps fell 15%. Jain pointed out that the 12% average small-cap decline masks the wider distribution of losses among individual stocks.

Delving deeper into market cap bands, losses worsen as company size shrinks. Stocks between Rs 250 crore market cap and Rs 750 crore have seen annual drops ranging from 20% up to 41%, with declines from 52-week highs and all-time highs escalating to 30–60% in some cases. Nearly 9% of small-cap stocks are down 50% or more from their 52-week highs, and nearly 70% of the segment has fallen at least 30%.

To understand if this is unprecedented, Jain analysed historical market cycles over the past 20 years. During periods when the Nifty fell 15% or more and consolidated, large caps averaged a 28% drop with a 23-month consolidation period. Midcaps fell an average 34%, consolidating for 28 months. Small caps endured the deepest corrections, dropping 42% on average and taking up to 38 months to stabilize. The deeper the correction, the longer the recovery period — small caps historically fall the most and recover the slowest.

Such sustained volatility invites the question: Why invest in small caps at all? Jain outlined that during strong bull runs, small caps tend to outperform significantly. For example, from pre-COVID times through 2020 and again in 2023-24, small caps surged, beating mid and large caps by wide margins. This outperformance often breeds investor confidence, especially among newcomers who may underestimate the fall volatility and panic once corrections hit.

Small caps’ intrinsic risk is tied to their design. Analysis of the CNX 500 index over 20 years shows that markets spend about 28% of the time in bear phases (declines over 15%), 55% consolidating within 15% of highs, and just 17% making new highs. Small caps spent more than 50% of the time in bear phases compared to just 20% for the Nifty. This greater exposure to prolonged downturns is why small caps carry higher risk but also offer greater reward potential.

The deep corrections create opportunities for growth as companies evolve from micro to small, then mid and large caps. Those who can withstand volatility can benefit from the multi-bagger growth potential small caps offer.

Regarding the current slump, Jain cautions that the market bottom remains uncertain and could still lie ahead. “Timing the exact bottom is very difficult,” he said. Historical data shows that some years favor large caps, others midcaps or small caps. Successful investing requires diversification across market caps to smooth returns and offset segment-specific weaknesses.

In summary, while small and mid caps are bleeding now, their historical cycles reveal extended pain but also potential for substantial long-term gains. Patient, diversified investors who understand and accept the volatility stand to benefit as these segments recover.