Owning a well-diversified set of stocks can both protect your portfolio during hard times and make you rich over the long haul. But if you're like many investors, you may have completely ignored a huge portion of the stock market -- and missed out on a whole class of stocks that bring you the best of both worlds.

When you first started investing, you probably focused on the giant companies that you knew best. Later, as you branched out and learned more about how to seek out even better performance, you may have started exploring small-cap stocks. But to put together a truly diversified portfolio, you need to bridge the gap between small and large companies. You might find the missing piece of your portfolio puzzle in mid-cap stocks.

The Goldilocks investment
In this month's brand-new issue of Motley Fool Champion Funds, you'll find a two-page feature that includes discussion of how mid-cap stocks can improve your investing results. Although definitions of what constitutes a mid-cap stock vary, they usually fall somewhere in the range of $1 billion to $10 billion market capitalizations and offer a just-right alternative between larger and smaller companies. With over a thousand stocks qualifying as mid-caps, you'll find a great assortment of companies, with both familiar favorites and some up-and-coming stocks that you may never have heard of.

The reason mid-cap stocks fall in the sweet spot is that they combine some of the best characteristics of both large and small companies. In particular:

  • Like large companies, most mid-cap stocks have an established track record of performance, both in their company financial statements as well as by creating shareholder value and seeing share prices rise. Those track records help limit the risk of mid-caps, especially in comparison to smaller companies that have less experience and are more prone to suffer potentially fatal setbacks.
  • Like small companies, however, many mid-cap stocks have only seen the beginning of their growth spurts. You may not enjoy quite as explosive returns as you'd earn by getting in on the ground floor of a great investment opportunity. But in comparison to larger companies that have already seen their best days and now languish in mature or even fading industries, mid-cap stocks can still deliver the promise of big gains in the future.

Looking at the returns of mid-cap stocks, you can see how they represent a fertile middle ground between large and small companies.

Index

5-Year Average Return

10-Year Average Return

S&P 500 (Large-Cap)

(4%)

(2.8%)

S&P Midcap 400

(2.2%)

4.3%

Russell 2000 (Small-Cap)

(4.5%)

2.2%

Source: Morningstar.

Avoiding the mid-cap value trap
Investing in mid-cap stocks does carry one unusual risk, however. In evaluating potential investments, you have to look closely and distinguish among companies that have grown up from small-cap status, versus those that have fallen from the large-cap ranks.

In the lifecycle of a typical company, businesses start small, grow to their full potential, and then either find new ways to profit as their initial strategies get old or fade back into smaller ranks. Obviously, you want to catch companies on their way up, not their way down.

But if you simply buy stocks based on market cap, you'll get some companies you might not want. Here's an example:

Stock

Market Cap

5-Year Total Return 

International Game Technology (NYSE:IGT)

$2.91 billion

(76%)

Alcatel-Lucent (NYSE:ALU)

$4.45 billion

(86.9%)

Sirius XM Radio (NASDAQ:SIRI)

$1.39 billion

(88.9%)

General Motors (NYSE:GM)

$1.83 billion

(92.1%)

Myriad Genetics (NASDAQ:MYGN)

$4.23 billion

474.4%

Hansen Natural (NASDAQ:HANS)

$3.20 billion

2,210.5%

Intuitive Surgical (NASDAQ:ISRG)

$3.78 billion

484.2%

Source: Capital IQ. Market Cap intraday on 3/26/09.

Learn more
So what's the best way to invest in mid-caps? Buying individual stocks can maximize your overall returns if you choose the top stocks. But because at least some active management is necessary to distinguish future champs from has-been stocks, many prefer to look at mutual funds. Foolish fund expert Amanda Kish looks at one great mid-cap fund prospect in this month's issue -- a fund that combines a value approach with the growth potential that mid-caps bring.

If you're curious about mid-caps -- or want to know what fund Amanda likes -- you won't want to miss out on this month's article. Not a subscriber? That's no problem -- our free 30-day trial offer makes it easy for you to get a sneak peek not only at this article but at the entire Champion Funds service, including back issues, exclusive online features, and much more. Check it out today and learn more about how mid-cap stocks can help you hit your investing sweet spot.

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Fool contributor Dan Caplinger owns a few mid-caps, though he tends to play the extremes more often. He doesn't own shares of the companies mentioned in this article. Hansen Natural and Intuitive Surgical are Motley Fool Rule Breakers selections. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy is always sweet.