Investing in small-cap stocks can be an emotional roller coaster. Small caps provide both the market's best returns, and its worst. They have the most room to run, but also the smallest margin for error. And extreme daily volatility with little news is not uncommon. Needless to say, small-cap investing is not for the faint of heart.

But in spite of the inherent risks, the growth potential of small caps is just too good to ignore. That's why many investors use a small-cap mutual fund or ETF to get their exposure to this capricious segment of the market.

And that's fine for most people. The important thing is that you have at least some small-company exposure in your portfolio. If you don't, you may be missing out on substantial growth opportunities. For instance, the Vanguard Small-Cap Index Fund, which tracks the broad small-cap market, returned 11.6% per year over the past five years, while the Vanguard S&P 500 Index returned 7.3%.

So even if you had just 20% of your equity portfolio allocated to the small-cap index fund, you would have improved your five-year returns quite nicely.

You can do better
While a mutual fund or ETF will diversify your small-cap holdings, it can also dampen the growth potential of your portfolio.

First of all, the fund could be spreading your investment across too many stocks. The Vanguard Small-Cap Index, for example, holds 1,750 stocks. One of the fund's top holdings, Synopsys (NASDAQ:SNPS), makes up only 0.2% of the total portfolio. So, theoretically, for every $1,000 you invest in the fund, only $2 goes toward Synopsys. Even if the stock doubles, it won't help your returns much.

Second, many small-cap fund holdings lean toward the mid-cap range of $2 billion to $10 billion, which prevents investors from truly benefiting from small-cap exposure. Consider that the top 10 holdings of the Vanguard Small-Cap Index have an average market cap near $4 billion, which is definitely in the mid-cap arena. Now, while these mid-cap stocks could end up performing well for investors, they naturally have less room to grow than a smaller company capitalized at $200 million, or even $500 million. In other words, a stock's multibagger potential tends to diminish as the company gets bigger.

Take concrete purveyor Florida Rock (NYSE:FRK) as an example. It's a $4.4 billion company whose stock is up 1,266% over the past 10 years. If Florida Rock were to grow another 1,266% over the next 10 years, it would become a roughly $60 billion company (not considering share buybacks or dilutive practices) -- comparable to the size of Sprint Nextel (NYSE:S), Bristol Myers (NYSE:BMY), and Medtronic (NYSE:MDT) today. To put that $60 billion figure in further perspective, Lafarge (NYSE:LR) is the largest cement company in the world, with a current market cap of $27 billion.

Get on board early
Instead of looking for companies that have already experienced tremendous growth, Motley Fool co-founder Tom Gardner and the Hidden Gems small-cap investing team look for companies that the market hasn't discovered yet.

They look for companies such as Volcom, a $900 million company and leading action sports brand. Moreover, the company is helmed by a founder/CEO who owns a significant percentage of the shares.

If you'd like to learn more about small-cap investing, or what the Hidden Gems team looks for in a quality stock, follow this link for a free 30-day trial to the service.

This article was originally published on Dec. 4, 2006. It has been updated.

Todd Wenning does not own shares of any company mentioned, but he does own a complete set of 1990 Fleer baseball cards. Volcom is a Hidden Gems pick. The Fool's disclosure policy reminds you that only you can prevent forest fires.