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Some investors love digging through obscure stocks, looking for a small company that's poised to get big. That can be a very profitable approach, but it's also risky: For every small company that gets big, delivering huge returns to investors, plenty don't -- and some just go bust, leaving investors with nothing.

For some, that's not a big deal. In their view, the winners more than compensate for the occasional blowups. But others, particularly folks in their 50s and 60s, are reluctant to take on that kind of risk. They resist adding small caps to their portfolios, thinking -- and this is a valid concern -- that as they get closer to retirement, their portfolios have less time to recover from major blowups. They're reluctant to put their futures at risk.

Does that describe you? If so, here's something to ponder: Adding small caps to your portfolio can actually reduce your overall risk.

Yes, I said "reduce"
We all know -- or should -- that in theory, spreading one's assets among multiple asset classes reduces risk while increasing your overall average return. That's the theory behind asset allocation, and most of us who pay attention to our retirement savings have tried those little calculators that supposedly figure out our risk tolerance and tell us we need to be 61% in stocks and 23% in bonds and so forth.

That's the big-picture stuff. But here's the thing: The same principle applies within each of those asset classes. Sure, buying shares of McDonald's (NYSE: MCD  ) or Johnson & Johnson (NYSE: JNJ  ) is one way to help fill up an IRA, and it's a pretty good one. Both of those stocks have high CAPS ratings and long histories of raising dividends.

But if you take a portfolio that's weighted heavily toward large-cap stocks and add some small caps -- you don't need a lot -- your returns should, on average, go up. And your portfolio's overall volatility will go down.

I know -- when it's laid out like that, it sounds counterintuitive. After all, small caps can be tremendously volatile -- just look at a long-term chart for FormFactor (Nasdaq: FORM  ) , a small-cap leader in technology that tests semiconductors for defects. Semiconductor manufacturing is a volatile industry, and you'd expect some volatility in the company's stock price -- but FormFactor's chart looks like a saw blade, all jagged edges and sharp turns.

Likewise the chart of Dawson Geophysical (Nasdaq: DWSN  ) , a seismic data acquisition company whose prospects are linked to oil prices: It's up, down, up, down, bouncing all around like a sugar-buzzed six-year-old. Now, these are both well-regarded companies in industries undergoing major upheavals -- that's part of what makes them "well-regarded" -- but that kind of volatility is fairly typical of small-cap stocks. 

It just doesn't seem to make sense that adding a stock like that to a portfolio full of blue-chips could reduce your overall volatility. But it really does work.

But you don't need to take my word for it. Instead, take Roger Ibbotson's.

It's not just a theory, it's science
If there's one guy who should know, it's Ibbotson. He's made a career out of compiling, analyzing, and publishing historical data on the returns of different asset classes. In an interview he did with Barron's back in 2006, Ibbotson maintained that adding small-caps to a portfolio would actually reduce risk -- volatility, in other words -- as long as the total proportion of small-caps to other assets was kept under a reasonable limit, 20% to 25%.

Still skeptical? So was Fool Robert Brokamp, the advisor for the Fool's Rule Your Retirement service. He broke out some sophisticated analytical tools and tested the theory, using the Vanguard 500 Index Fund (VFINX) as a proxy for the blue-chips and a small-cap fund as a proxy for, well, the small caps. And sure enough, a portfolio that was 80% blue chips and 20% small-caps would have had higher returns and less volatility over the past 10 years than just the blue chips alone.

It really works.

The easy way to add small caps
Just as in Robert's example, using a small-cap-focused mutual fund or ETF to make up that 20% is a great way to go if you don't want to take the time to dig for small-cap gems on your own. I tend to use ETFs in my own portfolio, because I think there are good reasons to avoid most mutual funds these days -- but when Robert wrote up his example for a Rule Your Retirement article, he named a couple of funds that look to me like shining exceptions to that rule.

One in particular was especially intriguing, because its return and volatility were both better than the S&P 500 fund -- and better than that fund in combination with the blue-chips. I hadn't looked at this particular fund before, but it's got all of the things we should look for in funds -- long-tenured managers, reasonable expenses, and great returns, coupled with relatively low volatility. Its top holdings include well-regarded companies AllianceBernstein Holdings (NYSE: AB  ) , GrafTech International (NYSE: GTI  ) , and Unit (NYSE: UNT  ) . All three are expected to see earnings grow at a moderate pace of around 10% annually over the next five years, and all of them currently have CAPS' highest rating of 5 stars.

If you're thinking about putting this strategy to work, you could do a lot worse than buying this fund. If you'd like to learn more about this fund, and about the principles behind this strategy, check out Robert's full article in the May issue of Rule Your Retirement, available online now. If you're not a member, just help yourself to a free trial -- you'll have full access for 30 days, with no obligation.

Fool contributor John Rosevear has no position in the stocks or funds mentioned. Unit Corp. is a Motley Fool Stock Advisor choice. Dawson Geophysical and FormFactor are Motley Fool Hidden Gems picks. Johnson & Johnson is a Motley Fool Income Investor pick. Motley Fool Options has recommended a bull call spread position on FormFactor as well as buying calls on Johnson & Johnson. The Fool owns shares of Dawson Geophysical, FormFactor, and GrafTech International. Try any of our Foolish newsletters today, free for 30 days. The Motley Fool has a disclosure policy.


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John Rosevear
TMFMarlowe

John Rosevear is the senior auto specialist for Fool.com. John has been writing about the auto business and investing for over 20 years, and for The Motley Fool since 2007.

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Related Tickers

8/26/2014 4:02 PM
AB $27.42 Up +0.03 +0.11%
AllianceBernstein… CAPS Rating: ****
DWSN $23.04 Down -0.08 -0.35%
Dawson Geophysical CAPS Rating: ****
FORM $7.19 Up +0.34 +4.96%
FormFactor CAPS Rating: ****
GTI $9.16 Up +0.26 +2.92%
GrafTech Internati… CAPS Rating: ****
JNJ $103.44 Up +0.21 +0.20%
Johnson & Johnson CAPS Rating: ****
MCD $94.11 Down -0.33 -0.35%
McDonald's CAPS Rating: ***
UNT $64.72 Up +1.25 +1.97%
Unit Corp. CAPS Rating: ****

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