So I'm driving ... and, uh ... a cop pulls me over. And he makes me get out. He looks at me and he says, "Heyyy ... are you small"? I said, "No-o-o! I'm not!" He said, "Well, I'm gonna have to measure you." They have this little test they give you -- they give you a balloon ... and if you can get inside of it, they know you're small. -- Steve Martin

For many of us investors (perhaps most of us), it makes a lot of sense to inject some small-cap companies into our portfolio. As Bill Barker pointed out in a recent article, between 1927 and 2004, small-cap "value" stocks (those deemed undervalued) handily outperformed large-cap value stocks, 15.4% to 12.4%. (Data from, ignoring the effect of inflation.)

Those three percentage points can make a big difference. If you invested $50,000 for 25 years and earned an average annual return of 12.4%, you'd end up with a very respectable $929,000. If you earned 15.4% instead, your end result would be nearly $1.8 million. That's a difference of almost a million dollars!

Now that you know .
Should you liquidate all your non-small-cap investments immediately and reinvest them in the market's field of eager little seedlings? No, no, no ... that's not what I'm suggesting. Instead, consider making sure that you have some exposure to small caps. Make it a decent chunk of your portfolio -- perhaps 10% or 20% or even 30%. Don't neglect other promising categories, such as large-cap companies and international investments. Larger, more established companies often carry less risk and the promise of more reliable, though slower, growth. International investments keep you from being too tied to just one nation's economy.

Of course, you may now be wondering just where to find the right small-cap firms. Well, I wondered the same thing. Then it occurred to me to seek out some of the top small-cap mutual funds and see what their top holdings were. Money magazine conveniently offered its list of best funds in its February issue, so I looked one up one of the funds -- the Third Avenue Small-Cap Value fund. According to its website, it has appreciated by an average annual rate of 23% over the past three years and 14% over the past five. What are its top holdings? Well, according to its most recently reported information, here are some of them:

  • Brookfield Asset Management (NYSE:BAM)
  • Whiting Petroleum (NYSE:WLL)
  • St. Joe (NYSE:JOE)
  • Sears Holdings (NASDAQ:SHLD)
  • Comstock Resources (NYSE:CRK)
  • Pogo Producing (NYSE:PPP)
  • Maverick Tube (NYSE:MVK)

So far, so good, right? Well, here's the rub: These are as of Dec. 31, 2005. Since then, for all we know, the fund managers may have sold off any of these holdings, or may have trimmed them, because of declining confidence or a stock price that's no longer the bargain it once was. This is typical with mutual funds -- the most we usually get is a list of holdings as of a few weeks or months ago, so some holdings may well have been pared down or sold off entirely by the time we hear about them. This means that as responsible investors, using this approach we'd probably need to study each contender a lot more. Given how busy I typically am and you probably are, that's not welcome news. Especially since I've never even heard of most of the above companies.

Still, checking out these companies will probably lead us to some compelling investments, since it's unlikely that most of the top holdings will change over a few months -- at least in top-notch funds with low turnover.

Another option
We're not out of strategies, though. One more thing we could do is let some smart people zero in on compelling small-cap stocks for us. We could do this by:

  • Just investing in some high-quality mutual funds that focus on small-cap stocks. Shannon Zimmerman has recommended a half-dozen in our Champion Funds newsletter, which you can try for free. Several are up more than 40% in less than two years, and one is up some 30%.

  • Letting Tom Gardner and Bill Mann point out some compelling buys in our Motley Fool Hidden Gems newsletter. They've made dozens of picks over a little more than two years, and their picks are beating the market at large by 26 percentage points on average. Try the newsletter out for free, and you'll be able to review the entire list of recommendations and access every past issue, as well as the current one.

Think of Steve Martin
So as you evaluate your portfolio, see whether you want to make any changes. And perhaps remember the prescient words of Steve Martin: "Let's get small."

Here's to a happier portfolio! (And, hey -- consider forwarding this article to anyone you care about. Just click on the "Email This Page" link near the bottom of the page.)

Selena Maranjian 's favorite discussion boards include Book Club , Eclectic Library, Television Banter, and Card & Board Games. She owns shares of no company mentioned in this article. For more about Selena, viewher bio and her profile. You might also be interested in these books she has written or co-written:The Motley Fool Money GuideandThe Motley Fool Investment Guide for Teens. The Motley Fool is Fools writing for Fools.