The 10 best-performing stocks of the past decade were obscure, ignored, and small. But what about the top 25? The top 50? The top 100?

It turns out that most of the stock market's greatest performers of the past 10 years were also obscure, ignored, and small.

Small stocks for big returns
From June 1996 through June 2006, there were 308 stocks that could have earned you greater than 20% annualized returns over the past 10 years -- turning a $10,000 initial investment into more than $60,000. Of those 308 stocks, 285 of them were small caps 10 years ago. That's more than 90%. While the companies run the gamut from high-tech players like semiconductor maker Microchip Technology (NASDAQ:MCHP) to low-tech (in a good way) mobile-home parts maker Drew Industries, the common thread is size.

Ten years ago, Microchip was a tiny $860 million company. Today, it's a $7 billion company whose technology is used across industries and finds its way into cars made by Ford (NYSE:F), General Motors (NYSE:GM), and DaimlerChrysler (NYSE:DCX). Drew Industries grew from its $100 million valuation to $650 million, rewarding shareholders along the way.

And Drew Industries, for one, is still growing. The company dominates its niche and has almost every trait investors should look for in a small cap: superior leadership, clear competitive advantages, a strong corporate culture, and superior returns on equity (approaching 24% over the trailing 12 months). Since we recommended it in our Motley Fool Hidden Gems newsletter, it has also returned more than 31% for our members -- and we're confident it will keep on performing over the long term.

Big stocks for smaller returns
There were only 23 mid- or large-cap companies that would have given you the same growth, and they're the cream of the crop: Danaher (NYSE:DHR) and Stryker (NYSE:SYK), to name two. And while the returns have been incredible from these companies -- both of which demonstrate some key traits of great small caps: strong financials, strong competitive position, strong leadership -- they're just not as prevalent as the small guys.

That's because it's difficult for larger companies to generate the same kind of growth as small caps. While Drew Industries grew from $100 million to $650 million, Danaher grew from a $2.4 billion valuation to be worth nearly $20 billion. While Danaher added substantially more value in absolute terms, the story changes when it comes to the stocks' percentage gains. Drew returned 650% to shareholders; Danaher returned 530%. Now, compare that with a much larger company such as Time Warner (NYSE:TWX). The company added $65 billion of value during the same 10-year span, but that increase resulted in just 400% gains for investors. That's a consequence of the Law of Diminishing Returns, and it's a simple and crucial point in investing.

The Foolish conclusion
Small caps are one area of the market where the individual investor has the opportunity to earn phenomenal returns, but there are also pitfalls. For every one of the 285 small caps that could have earned you greater than 20% annualized returns over the past 10 years, there were quite a few more that didn't make it. Small-cap stocks tend to carry considerably more risk than large caps, so investors must consider their investments very carefully.

That's why we advocate a diversified portfolio of select small caps for Hidden Gems subscribers. By focusing on factors like superior management and a strong balance sheet and enjoying the benefits of diversification, our small-cap recommendations have outperformed the market by more than 14 percentage points since we started.

Every investor should have at least some smart exposure to small caps, because the historical profits are just too good to pass up. If you'd like some help getting started in this incredible area of the market, click here to join our community free for 30 days.

This article was originally published on Feb. 6, 2006, as "325 Incredible Returns." It has been updated.

Tim Hanson does not own shares of any company mentioned. Time Warner is a Stock Advisor pick. No Fool is too cool fordisclosure, not even Tim.