Over the past five years, if you'd had 100% of your portfolio invested in the Vanguard 500 Index (FUND:VFINX), you would have seen 5.9% annualized returns. By comparison, the Vanguard Small-Cap Index (FUND:NAESX) returned 12.9% over the same period. By allocating even 10% toward the small-cap index, your returns would have risen to 6.6%; allocating 20% would have improved them to 7.3%.

Investors have a natural attraction to large-cap stocks, and that's understandable. Everyone's heard of Cisco Systems and Coca-Cola, after all, and most know what they do to generate revenues. There's also a lot of analyst and news coverage for large caps, so we all have a good way of knowing what these firms are up to. Sounds like a great deal, right?

Well, it is -- if you want to settle for lower returns.

Why you need small caps
According to research from NYU professor Aswath Damodaran, studies have consistently found that smaller firms "earn higher returns than larger firms of equivalent risk." During Damodaran's study period of 1927 to 2001, the smallest companies outperformed the largest ones with a 20% annual return versus 12% on a value-weighted basis. The outperformance was even greater on an equally weighted basis.

One reason is that small caps, being, um ... small, simply have more "room to run" than the big boys. You can get a better sense of this by looking at some of the top-performing large- and small-cap stocks over the past five years. First, some of the best companies with a market cap of more than $50 billion five years ago:

Company

Dec. 2001 market cap
(in billions)

Total return
(Dec. 2001 to Dec. 2006)

China Mobile

$68.8

119%

Toyota Motor

$92.4

144%

Bank of America

$99.4

66%

Wells Fargo

$74.1

62%

Sanofi -Aventis (NYSE:SNY)

$50.3

23%

PepsiCo (NYSE:PEP)

$83.3

33%

Now, here were the best performers for companies with a market cap roughly between $200 million and $2 billion (the universe we search to make recommendations for our Motley Fool Hidden Gems small-cap investing service):

Company

Dec. 2001 market cap
(in millions)

Total return
(Dec. 2001 to Dec. 2006)

Holly Corp. (NYSE:HOC)

$309

1,114%

MEMC Electronic Materials (NYSE:WFR)

$171

952%

Denbury Resources (NYSE:DNR)

$401

882%

Vimpel Communications (NYSE:VIP)

$1,019

845%

Tata Motors (NYSE:TTM)

$464

839%
*Data provided by Capital IQ, a division of Standard & Poor's.

Simply put, the smallest companies have much more upside than the largest. But be aware: Higher potential reward comes with higher risk. Buy one of the worst-performing small caps, and you'll likely earn a total loss of capital -- which is a fancy Wall Street phrase for "losing all your money." That's why at Hidden Gems we seek out only the highest-quality small caps: those with high insider ownership, a strong balance sheet, a solid business model, and compelling valuation.

It's time to think small
Using these principles, Tom Gardner and his team's stock recommendations have outperformed the S&P 500 by an average of 46% to 20% since the service began three years ago. This shows that small caps can indeed improve returns, and should be a part of any balanced portfolio.

If you're interested in a look at all of the Hidden Gems recommendations, Tom is offering a full-access, 30-day free trial to the service. Here's more information.

This article was originally published on Sept. 14, 2006. It has been updated.

Rex Moore has nearly mastered quantum mechanics, but is stuck on that "wave-particle duality" thingie. He owns no shares mentioned in this story. Bank of America is an Income Investor pick. Coca-Cola is an Inside Value pick. The Fool'sdisclosure policyshines year-round.