Chasing Returns: What Behavioural Economics Tells Us About India's Small Cap Frenzy

Over the past decade, India’s small cap segment went from being the investment your broker warned you about to the one everyone couldn’t stop talking about. What was once considered speculative was now mainstream, primarily due to increasing SIP participation, huge mutual fund inflows, and high media coverage. It was considered a perfect recipe for overnight wealth creation; until 2025 happened, and investors thereafter started receiving only a chunk of their "promised" profits. So what exactly went on here? Genuine opportunity recognition, or a classic case of narrative-driven optimism and herd behavior?

Truth be told, the answer is both.

The fundamental argument for small cap funds is not made up. These are companies ranked beyond 250 by market capitalization and operate mostly in emerging industries and specialized niches. Nimble, flexible, undercovered, and often underpriced, these are goldmines for sharp-eyed investors, often missed by the broader market and institutional investors. With 237 SME IPOs hitting the market in 2025 alone, India’s entrepreneurial explosion further broadened this opportunity. Moreover, these funds have annually generated returns between 19% and 20% on average in the long term, with some funds returning up to 25%, thereby outpacing mid-caps and large-caps.

But here’s where things get a little interesting and probably a little uncomfortable too.

When an asset class posts these kinds of numbers long enough, it surely catches the eyes of the masses. These humongous returns in comparison to the returns generated by Nifty 50 crafted a narrative, which, as economist Robert Shiller claims, spreads quickly like epidemics. Behavioral economics terms this phenomenon as “representative bias”—a type of mental shortcut in which continuous outperformance of a particular investment type with respect to its benchmark leads to the distortion of investor perception of fundamentals. This, combined with bounded rationality—the simple fact that individuals make decisions under the constraints of limited information, limited time, and limited computational ability—creates the perfect base for herd behavior. When everyone else is piling up with small caps, sitting along the sidelines feels like the riskier choice.

By the first quarter of FY2026, the small-cap stocks were absorbing up to one-third of the total equity inflows, all thanks to social media and algorithmic recommendations. Valuations quietly became untethered from reality. Small caps were trading at a 28% premium to their five-year average, with P/E multiples of 25-29 against a historical average of 16.7. Around two-thirds of the stocks in the segment were priced beyond what their fundamentals could justify. But when the mood is euphoric, nobody wants to reason.

In 2025, the mood changed and the correction happened. Small caps fell anywhere between 7% and 22%, and investor confidence kept going downhill. The FII pulling out Rs1.66 lakh crore, the unsatisfactory union budget, and the RBI rate cuts not meeting expectations—everything fueled the fire further. The same psychological phenomena that fueled the rally had brought about its downfall. An insight can be taken from the prospect theory, which states that humans perceive losses more strongly than they do gains. As stock prices declined, fear overtook any rationality in their evaluations, and investors tried to liquidate their positions in order to minimize their losses, therefore leading to the massive selloff; after all, panic is just overconfidence in reverse.

In conclusion, the narrative of small cap funds in India illustrates an underlying principle about financial markets: that they are as much affected by the psychology of the human race as they are affected by the economics of the markets. The narrative was not meant to criticize small-cap stocks but to critically examine the behavioral forces that lead to correction in the segment, something that cannot be explained by spreadsheets alone. Therefore, to distinguish between sustainable opportunities and herd mentality-driven speculation, one needs more than just a stock screener—better psychological awareness.

References

Agarwal, N. (2025, August 4). Retail investors dump 68% of nifty stocks chasing smallcap Crorepati Dreams. is this a trap?. The Economic Times. https://m.economictimes.com/markets/stocks/news/retail-investors-dump-68-of-nifty-stocks-chasing-smallcap-crorepati-dreams-is-this-a-trap/articleshow/123085733.cms

Bhuvan. (2025, January 10). The dramatic transformation of the Indian Stock Market. Z. https://zerodha.com/z-connect/subtext/the-dramatic-transformation-of-the-indian-stock-market

Chen, J. (2025, July 15). Prospect theory: What it is and how it works, with examples. Investopedia. https://www.investopedia.com/terms/p/prospecttheory.asp

Malkiel, B. G. (2023, April). The efficient market hypothesis and its critics by. https://www.princeton.edu/~ceps/workingpapers/91malkiel.pdf

Gupta, Y. (2025, October 13). IOSR Journal of Business and Management (IOSR-JBM). IOSR Journal. https://www.iosrjournals.org/iosr-jbm.html

Hajur, M., & Thavara, S. (2025). Analyzing Herding Behavior: A Study Of Investor Trends In Indian Stock Markets. Sachetas, 4(3), 1-7. https://doi.org/10.55955/430001

Khanna, S. (2025, July 28). Smallcap mutual funds dominate return charts in 5 & 10 years. what’s driving the surge? The Economic Times. https://economictimes.indiatimes.com/mf/analysis/smallcap-mutual-funds-dominate-return-charts-in-5-10-years-whats-driving-the-surge/articleshow/122945492.cms?from=mdr

Nair, S. (2025, December 29). Mid Caps, small caps crash in 2025; Retail Investors Turn Net Sellers. Bloomberg.com. https://www.bloomberg.com/news/newsletters/2025-12-29/mid-caps-small-caps-crash-in-2025-retail-investors-turn-net-sellers

Shitole, A. (2025, April 15). A comparative study of selected small - cap mutual funds in India. International Journal of Science and Research (IJSR). https://www.ijsr.net/getabstract.php?paperid=MR25407094221

TOI Business Desk / TIMESOFINDIA.COM /  Aug 05, 2025. (2025, August 5). Retail fund flows surge: Mid, smallcap schemes draw rs 20,255Cr in Q1; investors chase high returns despite expensive valuations. The Times of India. https://timesofindia.indiatimes.com/business/india-business/retail-fund-flows-surge-mid-smallcap-schemes-draw-rs-20255cr-in-q1-investors-chase-high-returns-despite-expensive-valuations/articleshow/123124364.cms