Most people, especially in our Indian society prefer assurance and stability. Parents want their children to get good education, so that they feel reasonably assured that their children will get good jobs and stability in careers.Once children get settled in their jobs, parents want them to get married, so that they settle down in their lives as well. Stability is comforting for people. Volatility, on the other hand, is the exact opposite of stability. From an investment perspective, volatility is associated with the fear of losing money.

Volatility in investments can be stressful, especially for new investor. New investors are mostly young investors, who are a few years into their careers. Their savings are limited and the prospect of losing hard earned money can make new investors fearful. Therefore, most retail investors in India prefer to keep their savings in safeinvestments like bank FDs, Government small savings schemes, life insurance endowment plans or in physical Gold; equity is seen as a risky asset class.

Equity is volatile but the best long term asset class

Risk and return relationship is a fundamental concept in finance. The more risk you take, the more returns you will get. While equity is a volatile asset class, historical data shows that it is the best performing asset class in the long term. Rs 1 Lakh invested in Nifty-100 would have grown to Rs 15 Lakhs in the last 20 years, whereas the same amount invested in Gold and bank Fixed Deposits would have grown to Rs 7.4 Lakhs and Rs 4.1 Lakhs respectively.

If you completely avoid taking risks, you are losing out on the opportunity to grow your money. Your risk taking ability will change as you progress through different life-stages. Risk taking ability is highest when you are young, it reduces as you grow older and after you retire your risk taking ability is usually quite low. Why is risk taking ability high when you are young? Time is the most important factor in investments - when you are young, many of your life’s long term goals are far away in time. Even if you make a loss, you will have sufficient time to recover your losses before you reach life’s important milestones; when you are older, you will not have sufficient time. Since your risk taking ability is high when you are young, equity is the best asset class because it will give you the highest returns in the long term.

For example –

Risk capacity versus risk appetite

There are two aspects of risk taking ability – risk capacity and risk appetite. Risk capacity is your financial capacity to absorb losses in the short to medium term. As discussed earlier, risk capacity is highest when you are young and progressively reduces with age. It is also depends on your income, savings and debt obligations. Risk appetite on the other hand, refers to how much volatility you can stomach. It differs from individual to individual, depending on their individual personalities. It also depends on investment experience of investors. Experienced investors have higher risk appetites, because they are more likely to have seen their investments go down in value and recover again. New (inexperienced) investors on the contrary, are likely to have low risk appetites. It has been seen that, sometimes senior citizens / retires have more risk appetite than a young investor in his 20s or early 30s, whereas their risk capacities should be completely opposite.

Ideally, investment decisions should be made purely on the basis of risk capacity, but in reality we see that, investment decisions are influenced by risk appetite. In practical situations, the influence of risk appetite cannot be wished away;investors should therefore, factor in both risk capacity and risk appetite when making investment decisions.

Risk Profile of market segments

Different segments of the equity market (stock market) have different risk profiles. The large cap segment is the least volatile, while small cap is the most volatile segment of the market. The risk profile of the midcap segment is somewhere between large cap (more risky than large cap) and small cap (less risky than small cap).

Let us now discuss why large cap segment is less volatile than midcap and small cap segments.

What is Large Cap

Different stock market segments refer the market capitalization levels of the stocks in the respective segments. As per SEBI’s circular to Asset Management Companies, the 100 largest publicly listed companies by market capitalization are classified as large cap companies. The next 150 companies by market capitalization are classified as midcap companies and the rest are small cap companies. Large cap companies as the name suggests are large and well established companies with fairly long histories. They have strong brands, large revenue base and are usually market leaders in their respective industry segments.

Risk characteristics of large cap stocks

Large cap companies have large balance sheets and are usually perceived to be better positioned to withstand economic downturns. In the past, we have seen that some small cap companies were not able to survive through long and severe economic downturns or in some cases, even if they did, their balance sheets were so badly damaged that it took a very long time for their share prices to recover. Large cap companies are therefore, seen by most investors as safer investments. As a result, investors are usually ready to pay a premium for these stocks.

Large cap stocks are usually much less volatile than midcap and small cap stocks. While large cap stocks tend to underperform midcap and small cap stocks in bull markets, they outperform in volatile market conditions when the broader market sees corrections. The broader market has been volatile this year (2018), but the Nifty 50(index of 50 largest companies by market cap in India) hasrisen by 8.7% on a year to date basis, while theNifty Midcap 100 has fallen by more 9%and theNifty Small Cap has fallen by more than 18%. Since large cap stocks are less volatile than midcap and small cap stocks, they are ideal investment options for new investors, who may not have high risk appetite, for creating long term wealth.

Large cap equity mutual funds

Equity mutual funds are the best investment options for retail investors who want to invest in equity markets. Mutual funds pool money from a large number of investors and invest the corpus in diversified portfolio of stocks. Diversification reduces stock specific and sector specific risks for investors. Further, mutual funds are managed by experienced fund managers who are tasked with beating the market and generating superior risk adjusted returns (alphas) for investors. Large cap funds invest primarily in large cap stocks. We think these investments are ideal for less experienced investors, who want to create long term wealth.

Wealth creation potential of large cap funds

There is a misconception among some investors that large cap mutual funds have limited wealth creation potential and that one has to take high risk by investing in midcap or small cap mutual funds to create wealth. We will show with the help of a few examples, how large cap funds over sufficiently long investment tenors created substantial wealth for investors.

The chart below shows the growth Rs 1 Lakh investment in Aditya Birla Sun Life Frontline Equity Fund over the last 15 years.

The investment grew more than 23 times in the last 15 years.Growth in investment was 5 to 9 times more than Gold and FD (see table below).

The chart below shows the growth of Rs 1 Lakh investment in HDFC Top 100 Fund over the last 15 years.

The investment grew more than 27 times in the last 15 years. Growth in investment was 5 to 10 times more than Gold and FD (see table below).

The chart below shows the growth of Rs Rs 1 Lakh investment in Franklin India Bluechip Fund over the last 15 years.

The investment grew more than 20 times in the last 15 years. Growth in investment was 4 to 8 times more than Gold and FD (see table below).

Conclusion

In this article, we have discussed why large cap mutual funds are ideal investment options for new investors. They are less volatile compared to other categories of equity mutual funds and at the same time, over long investment tenors, they can create substantial wealth. They are good investment choices for long term goals like retirement planning, children’s education, marriage etc.

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