It was widely expected that domestic inflows in India would play a more significant role than foreign investments, and this has indeed come to fruition. Over the past three to four years, domestic investments have grown at a faster pace than FIIs, driven by a strengthened financial culture. Today, equities have emerged as a significant investment avenue for domestic investors, who are increasingly diversifying their portfolios beyond traditional assets such as bank deposits, gold, and real estate, viewing the stock market as a long-term wealth-building opportunity. 

In 2024, mutual funds recorded a net investment of ₹4.3 lakh crore, while retail direct investments reached ₹1.2 lakh crore — the highest figures ever witnessed in India. Meanwhile, FIIs exhibited muted activity, with a net outflow of ₹9,600 crore during the year. The surge in domestic inflows in the last 3-4 years has significantly contributed to the strong performance of mid and small-cap stocks, a preferred investment segment for retail investors.

That is the reason why the premiumisation of mid & small caps, flourished post 2020. For example, by 2024, the premium valuation ratio of mid-caps to large caps had risen to 60%, three times the long-term average of 20%. This growth was primarily fuelled by robust domestic investments, particularly through mutual fund schemes targeting mid and small caps, along with direct retail participation. 

Despite strong investments in these segments, mid and small-cap stocks have faced considerable declines over the past five months. Retail investors are often the most affected when global market conditions become volatile. So far this year, over the past two months, India’s large-cap stocks have fallen by an average of 7.5%, while small-cap and micro-cap stocks have seen sharper declines of 23–25% on average.

It was widely believed that strong domestic inflows would reduce the historical impact of FII selling on the Indian stock market. This appears to hold true for large-cap stocks, in some extent as where corrections have been relatively milder compared to the broad market due to strong absorption by DIIs. Since FIIs have limited exposure to mid and small-cap stocks, their direct selling pressure in these segments may be constrained. However, the unprecedented FII sell-off of ₹2.2 lakh cr over the past five months, the biggest ever, has driven a broad market correction of approximately 20%.

The mid and small caps have started to be deeply impacted in 2025 because of the reduction in the domestic net inflows (table). FIIs are continuing to sell in India with the same negative vigour and domestic buying has contracted. Net inflow from MF & Retail has reduced in the last 2 months, increasing the negative side of the FIIs selling and reduction in stock prices because of lack of demand. 

This is because the confidence of retail investors is contracting due to continued selling by FIIs led by persistent consolidation of global market. Recently, the global risk has increased due to differences between US and European views regarding international geo-politics and trade. The uncertainty of a 25% tariff in Mexico & Canada and an additional 10%in China, to be deployed on 4th March, is adding ambiguity in the short-term.

Between September and December 2024, despite heavy FII selling, the Indian market remained resilient, supported by strong buying from mutual funds and retail investors. However, ongoing global headwinds continue to pressure the domestic market, with persistent volatility creating uncertainty among retail investors. 

From a long-term perspective, India has been the best-performing emerging market over the past five years, with MSCI India delivering a 17% CAGR. However, in the short term, it has been one of the weakest performers as FIIs continue to book profits. The current impact is more pronounced in sectors and stocks where earnings growth is below the long-term average, due to short-term disruption. This has created an opportunity for long-term investors. Looking ahead, the pace of earnings downgrades is expected to ease, supported by increased government spending, lower interest rates, and tax reductions. These factors are likely to provide a boost to sectors such as FMCG, consumer discretionary, banking and chemicals, which are trading at fair valuation today.

The author, Vinod Nair is Head of Research at Geojit Financial Services.

Disclaimer: The views and recommendations made above are those of individual analysts or broking companies, and not of Mint. We advise investors to check with certified experts before making investment decisions.