Each month in Motley Fool Hidden Gems, Tom Gardner and I present our favorite small-cap stock ideas to thousands of subscribers. The service has proven successful; our total average returns have topped the market 26% to 10% since the service began three years ago. But even though we've done a pretty good job at picking stocks, it's still very tough for us, or anyone, to predict which of our ideas will perform the best.

Write it down
As an exercise, I'll often rate my stocks in order of the confidence I have in them. Sometimes, this leads me to sell a stock, but not always. I rate several different elements: earnings and cash flows, business tenor, growth probabilities, competitive environment, management, and so on. It's a worthwhile exercise for everyone, but it also has its flaws, since what I consider valuable doesn't always correlate with the stock's actual performance.

That doesn't mean such rankings aren't worth doing, but it does speak to the power of diversifying your portfolio. Not too broadly -- you want your winners to matter. But if you restrict yourself to six stocks, and your seventh-best idea turns out to be the next Microsoft (NASDAQ:MSFT) in terms of growth, you'll miss out on something that could transform your financial future. In fact, I had a friend who traded in and out of Microsoft in the 1990s. He was proud of the gains he made, picking off a few hundred dollars here and there. But it was quite a surprise to him when we figured out one day that if he'd just kept his first investment in the company without selling, he would have been a multimillionaire.

Consider the following example:


10-yr. Return

$5,000 Invested




U.S. Steel (NYSE:X)



Merck (NYSE:MRK)









American Eagle Outfitters (NASDAQ:AEOS)



S&P 500



Granted, this is just an example portfolio, but the returns are real, and I think it drives home the benefits of a reasonable amount of diversification. Most of the stocks in the chart did pretty well, but American Eagle would have been that "transformational" stock I alluded to earlier.

Foolish bottom line
Since you can never be completely sure which of your stocks will be the next multibagger, it's important to diversify your picks -- especially in the small-cap realm. It's a principle Tom and I teach in Hidden Gems, and each month we both publish a list of our top five best recommendations for new money now, along with our normal two monthly picks. If you'd like to take a look at these stocks and the rest of our service, you can do so with a 30-day free trial. There's no obligation to subscribe.

Bill Mann is co-analyst of the Motley Fool Hidden Gems small-cap investing service. He owns no companies mentioned in this article. Microsoft and Gap are Inside Value selections. Merck is an Income Investor pick.Gap and American Eagle Outfitters are Stock Advisor recommendations.The Motley Fool has a disclosure policy.