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 January 1997 through December 2006, there were 348 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 348 stocks, 325 of them were small caps 10 years ago. That's more than 93%. While the companies run the gamut from high-tech players like flash card maker SanDisk (NASDAQ:SNDK) to low-tech (in a good way) oven maker Middleby, the common thread is size.

Ten years ago, SanDisk was a teeny-tiny $217 million company. Today, it's a more than $8 billion company that counts giants such as Sony (NYSE:SNE), Canon (NYSE:CAJ), and Motorola (NYSE:MOT) among its partners. Drew Industries grew from its $53 million valuation to $850 million, rewarding shareholders along the way.

And Middleby, 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, and impressive and improving returns on equity and assets. Since we recommended it in our Motley Fool Hidden Gems small-cap investing service, it has also returned more than 480% for our members -- but 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: Apple Computer (NASDAQ:AAPL) and Lowe's (NYSE:LOW), 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 brand, 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 Middleby grew from $53 million to $850 million, Lowe's grew from a $6.2 billion valuation to be worth nearly $50 billion. While Lowe's added substantially more value in absolute terms, the story changes when it comes to stocks and percentages. Middleby stock increased 1,542%; Lowe's increased 600%. Now compare that with a much larger company such as AIG (NYSE:AIG). The company added $135 billion of value during the same 10-year span. Yet that increase resulted in just 179% 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 325 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 27 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. Microsoft is an Inside Value pick. No Fool is too cool for disclosure.