This Is Why You Don't Stand on the Sidelines

Despite the volatility of 2007, the Dow Jones Industrial Average broke 14,000 for the first time ever in October. Even though credit and subprime fears hit the market toward the end of the year, the Dow still ended the year up more than 6%.

Of course, 14,000 wouldn't last and the Dow, the index made up of 30 of the largest, most widely held stocks in the United States, has retreated to 12,300.

Long-term investors, however, need to remember that while there will be plenty of hiccups and down times along the way, the stock market tends to go up, up, and up. Whether you bought the Dow high (10,700) or low (7,200) in 2002, you've still made money to date. We suspect that when we look back a few years from now, we'll likely be able to say the same thing about buying the Dow in 2007 and 2008.

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 6.37% 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 market has been deflated by tech-stock euphoria, then deflated more by corporate corruption, and then deflated some more by geopolitical catastrophes ... yet it has bounced back each time.

Then, in May 2006, the market fell into another one of its mood swings. It happened again in late February 2007 and then again this past autumn. It's in a mood swing again right now -- in fact, it's gotten many folks thinking we're in a recession, a bear market, or both. But guess what? The market has historically showed great resilience, bouncing back to reward long-term investors.

If the market continues to trend down, however, you'll hear a lot about a "flight to quality." That means buying steady, dividend-hiking consumer brand powerhouses such as Wrigley (NYSE: WWY) and Coca-Cola (NYSE: KO).

While that's fine advice, if you own 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 components -- or component-to-be Chevron (NYSE: CVX), which is entering the index next week -- we don't think one Dow stock will outpace the others by anything more than a few percentage points over the next few years. In other words, the reward for your work may be 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. And just take a look at some of that index'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 stocks were all small caps 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. Neither Tim nor Brian owns shares of any company mentioned. Netflix is a Stock Advisor pick. Coca-Cola is an Inside Value selection. Wrigley is an Income Investor pick. The Fool's disclosure policy is always Googling itself.