There are many different categories stocks can fall under, but one of the most common ways to classify them is by size (based on market capitalization). In this vein, there are three main categories: small-cap, mid-cap, and large-cap.

Small-cap stocks are those with a market cap between $300 million and $2 billion; mid-cap stocks range from $2 billion to $10 billion; and large-cap stocks are those above $10 billion.

There's no "right" one to invest in, and proper diversification encourages investors to own a mix of different-sized stocks. But let's take a look at small-cap stocks and examine what they can do for your portfolio.

Higher risk-reward proposition

Contrary to their name, small-cap stocks are not necessarily young companies that recently went public, although they can be. Many have mature businesses and have been around for quite a while. A small-cap stock may simply operate in a smaller market. In today's environment, after the steep sell-off this year, a lot of mid-cap stocks have fallen back into small-cap territory as well.

Small-cap stocks generally present a bigger risk-reward proposition, because they can grow faster than their larger peers but also come with greater risk, because there may be more volatility in their earnings reports quarter to quarter. They also may not have the same impregnable balance sheets investors tend to flock to during a recession.

But I love small-cap stocks and would recommend having at least a few in your portfolio, especially if you have a long-term investment horizon. Small-cap stocks give the average retail investor an opportunity to outperform institutional investors and the broad market. For example, the Russell 2000 small-cap stock index has beaten the benchmark S&P 500 and Dow indexes since the turn of the century.

^RUT Chart.

Data by YCharts.

Why can small-cap names outperform?

Small-cap stocks aren't as heavily covered by analysts on Wall Street, because these equity research teams are usually part of investment banks that use analyst coverage as a way to drum up business. There's more incentive for analysts to focus on bigger companies with more money to spend. Additionally, many mutual funds internally choose not to purchase small-cap stocks because of their greater potential for volatility.

This leaves a lot of room for investors to find great companies flying under the market's radar. Let me give you a few examples from my own portfolio. One small-cap stock I own is Silvergate Capital (SI 1.79%), which has a $1.67 billion market cap as of this writing. Silvergate is one of the first banks that built a real-time payments system specifically for large cryptocurrency traders and exchanges, because the U.S. banking system doesn't operate in real-time, while crypto trades around the clock.

When the price of Bitcoin took off in 2020 and 2021, the stock had a first-mover advantage and surged as more institutional investors started to trade crypto. While things have cooled off during the crypto winter, I still expect more institutional traders to move into crypto trading long term, which positions Silvergate well. Now, this is an early market, and its future is still uncertain, but you can also see how much growth potential it might have with the institutional space still in the early innings of crypto trading.

Another example is a real-estate stock called Seritage Growth Properties (SRG -0.08%), which has a market cap of about $650 million. Originally spun out from Sears to maximize the value of the retailer's real estate, Seritage has really struggled since the start of the pandemic. Recently, management said it's planning to sell all of the company's remaining assets, pay off its debt, and distribute the remaining earnings to investors. The stock currently trades at $11.30 per share, but management expects the distribution proceeds from the liquidation to range from $18.50 to $29.00 per share. Just one analyst covers the stock.

Years of struggles and concerns about the mall and shopping center real estate that makes up Seritage's portfolio have kept the stock trading at a huge discount to the liquidation estimates. But even at the bottom of the range, investors could enjoy a more than 60% return in approximately two years' time.

Buy some small-cap stocks

Everyone has their own investing strategy, and there's no requirement to buy small-cap stocks. However, all but the most conservative and risk-averse investors could benefit from dedicating at least a small percentage of their portfolios to these stocks.

They've proven they can outperform the broad market long term, and they give investors a better chance of finding overlooked gems.