This Is Why You Don't Stand on the Sidelines

The Dow Jones Industrial Average opened this morning above 13,350 -- up more than 16% year over year. If you hadn't been around for the volatility of the last month, you'd be elated.

Instead, because the market has dropped 5% since mid-July, investors are panicking.

A primer
We've written before about the powerful long-term returns the stock market offers. In fact, some readers would no doubt accuse us of beating that horse one too many times (gory as that image may be).

But it's not something to be taken for granted. Have you heard the now-famous story Warren Buffett told in an early shareholder letter? The gist of it goes like this: In 1636, the Dutch purchased the island of Manhattan for $24 worth of glass beads. In 2004, the assessed value of the island's properties was $186 billion.

That's just a 6.4% annualized return -- meaningfully less than the 10% or so the stock markets have returned over the past century, even despite economic troughs!

Stuff happens
Look, the world goes round and round, and bad things happen sometimes. Just in the past decade, the markets have been deflated by the collapse of tech-stock euphoria, then deflated further by corporate corruption, and then deflated even more by geopolitical catastrophes ... yet they've bounced back each time.

Today, the market seems to be in another one of its mood swings -- brought on by the crises in the credit market. Yes, we could be in for some pain. But if history is any indication, the market will bounce back again.

If the market continues to trend down, however, you're going to hear a lot about a "flight to quality." That means buying big blue chips such as ExxonMobil (NYSE:XOM), General Electric (NYSE:GE), and Citigroup (NYSE:C).

While that's fine advice, if you hold a substantial stake in an S&P 500-tracking fund, you already have a ton of exposure to that market segment. And while you'll likely do fine by sticking with large caps and index funds, you can do better.

What would you do with a dollop?
How can you do better? Well, let's clear this up right now: For the extra juice, do something Buffett can't -- think small. While you can do extensive research into valuing Dow members, we don't think that one will outpace the other by anything more than a few percentage points over the next few years. In other words, the reward for your work is nominal when you can just get them both in a low-cost fund.

Peter Lynch, a man we admire very, very much, said it best in his classic One Up on Wall Street: "The size of a company has a great deal to do with what you can expect to get out of the stock. ... Specific products aside, big companies don't have big stock moves."

The spread between the best and worst small caps, on the other hand, is much, much wider.

Why small? Or, better, why small caps?
Remember the DJIA? Well, the small-cap Russell 2000 index has an even more impressive trajectory -- despite its recent slide. And just take a look at some of the market's biggest gainers of the past five years.

Those are the glitzy returns that will put your portfolio into overdrive. And what do they have in common? That's right: These small caps were all even smaller when their amazing runs began.

Let's face it -- we can hem and haw about which large caps are the best buys right now, but all of that work will help us do only a little bit better. If, however, we spend our time deciding which small caps are the best buys right now, maybe -- just maybe -- we'll hit on the next 20-bagger. That's the promise of small-cap investing and the reason we offer our Motley Fool Hidden Gems service to interested investors.

As Peter Lynch said, "Everything else being equal, you'll do better with the smaller companies." So if you don't have at least a little small-cap exposure, just think of how much better you could be doing.

This article was originally published on Sept. 21, 2006. It has been updated.

Tim Hanson and Brian Richards invite you to be their guest at Hidden Gems free for 30 days. Just click here for more information. Tim owns shares of Aladdin Knowledge Systems. Brian does not own shares of any company mentioned. The Fool's disclosure policy is always Googling itself.