There are always reasons not to invest: risk, valuation, competition, interest rates, oil prices, et cetera, ad nauseum. But risks are compensated by rewards. That's how the stock market works.

You'll lose your shirt
One of the most paralyzing risks is that we'll lose money investing in small companies. But we should be prepared to also make quite a bit of money in small caps. Unless your crystal ball is back from the shop, each outcome will happen to you. So let's embrace the gruesome truth. Yes, you're going to suffer some losses in small caps. In fact, you may even have the great (mis)fortune to see one of your holdings go all the way to zero! But the opportunities in small caps outweigh the crises.

For example, let's assume a hypothetical Motley Fool Hidden Gems subscriber has been with the service since its launch with the July 2003 issue. Our hypothetical investor bought recommendations on the dates announced and held unless a formal "sell" recommendation was given. Let's further assume that this subscriber has had fairly bad luck in picking the stocks -- let's say our mystery man scooped up the five biggest decliners since the newsletter's inception, while only picking a single winner. That winner, however, has been the most successful of all Hidden Gems recommendations: Middleby (NASDAQ:MIDD). Putting equal amounts into each position, how has he done when saddled with the five underachievers?

Company Issue Stock Price Return S&P 500Return
Middleby Nov. 2003 $18.47 387.2% 23.2%
eSpeed* (NASDAQ:ESPD) March 2004 $19.94 (54.2%) 11.5%
QLT** (NASDAQ:QLTI) Nov. 2004 $16.52 (53.9%) 13.2%
CardioDynamics* (NASDAQ:CDIC) Dec. 2003 $5.67 (43.8%) 20.8%
Montpelier Re (NYSE:MRH) April 2004 $34.14 (43.6%) 8.3%
CryptoLogic (NASDAQ:CRYP) March 2005 $25.20 (29.3%) 7.0%
* Sold on March 24, 2005.
** Sold on Sept. 22, 2005.

Assuming $1,000 invested in each position, that $6,000 would be worth $7,624 as of this writing, for a total portfolio gain of 27.1%. If that $1,000 had been invested in the S&P 500, the gain there would have been an aggregate 14%. Our mystery guest would be besting the benchmark by 13 percentage points with but a single feather in his cap. And this is a cherry-picking example on both the positive and negative ends. Fact is, as of this writing, a quick look at our Hidden Gems scorecard shows lead analyst Tom Gardner's picks being up an average 33.7%, and the guest analyst slot (now featuring Bill Mann in a recurring role) up an average 36.8%, versus the average market benchmark of 12.5%. And this includes the five losers listed above, as well as another four double-digit decliners since recommendation.

Diversification means you can take some losses and still profit.

Circle of life ... err ... competence
One of my favorite money managers is Avner Mandelman of Giraffe Capital. Now, while Warren Buffett may be famous for avoiding technology, Mandelman is (somewhat less) famous for sticking almost exclusively to technology, and finding value therein. (And he's been rather successful at it, too). The common thread here? Each investor stays within his circle of competence to avoid losing money on something he knows nothing about.

My own personal war wounds came circa 2000, when I had some painful run-ins with a few fiber-optics companies. I didn't fully understand those businesses, but I didn't want to miss out on the growth. Those losses hurt.

As a result, I completely missed former Hidden Gems pick Transkaryotic Therapies and its 215% gain from recommendation to acquisition last year by Shire Pharmaceuticals (NASDAQ:SHPGY). But I'm confident I can make up that gain investing in companies I understand quite well.

Be not afraid of missing an opportunity when you don't passably understand a company, technology, or business model. Other opportunities will come. The scariest thing in the market is the unknown.

As John Maynard Keynes famously said, "When the facts change, I change my mind. What do you do, sir?" Take another look at that list of the five biggest decliners again, and note that three of the five are no longer with us.

The lesson here? Be not afraid of taking a loss -- even if your ego won't initially let you admit you were wrong. When you see shortfalls, recognize them. In the case of eSpeed, it was disquiet with management's ability to define its competitive advantages when asked, as well as a bitter feud with its biggest competitor. With CardioDynamics, it was unease with management's excuses and rosy optimism set against a significant number of end users dismissing the product.

As a "numbers guy," I hate to admit it, but there's not a large moat around the art of massaging and understanding the financials. Anyone properly trained can calculate ratios, run a discounted cash flow analysis, or use an option-pricing model. But growing appreciation of the intangibles of management and of the defensibility of competitive advantages has been of great value to me as an investor. These losses, and the documented rationale for selling, have greatly aided my education.

The Foolish bottom line
Losses happen, and they're not fun. But learning from these experiences can make us all better investors, and being reasonably diversified will limit the overall portfolio damage. Admit mistakes and learn from them. I've always told my wife that I'll make a lot of mistakes (she's surprisingly nonplussed when I say that ... hmmm), but I promise I'll only make each mistake once. Avoid chasing hot story stocks for fear of being left behind, and conversely, don't be afraid of buying the fallen or boring. Finally, consider joining us in Hidden Gems. Peruse the back issues, kick the tires on the newly redesigned members-only website, and take a walk on the message boards to join in on some conversations.

Be not afraid. Market-beating returns await.

Jim Gillies owns shares of CryptoLogic and Montpelier Re. Middleby, CryptoLogic, and Montpelier Re are all Hidden Gems recommendations. The Fool has adisclosure policy.