In "These Stocks Will Burn You," I cautioned against getting too excited about the potential for making millions in small-cap stocks. Not because small companies don't present the chance for huge gains; I could give you any number of examples like NVIDIA's (Nasdaq: NVDA) 1,024% gain since it went public in 1999, or Valero Energy's (NYSE: VLO) 1,135% run-up over that same period. A modest $5,000 investment in each of those would have returned you more than $100,000.

No, I'm simply warning you that such high potential reward comes with equally high risk. It's one of the laws of investing, one we teach about constantly in our Motley Fool Hidden Gems small-cap investing service. You need to do all you can to avoid having a stock or two inflict years' worth of damage on your portfolio.

So how can we Fools reduce the risk involved while still keeping the potential reward sufficiently high? Two things.

First, pay attention to the balance sheet, and stay away from companies that are overleveraged with debt and burning through lots of cash. In my original article, I recommended sticking with profitable companies with cash-to-debt ratios of at least 1.5.

Second, buy two, three, or even more of these small fries with the same total amount of cash you'd normally allocate to one position. If $6,000 is all you're comfortable allocating to a "normal" stock purchase, try buying three small caps you like at $2,000 apiece. That way, if one crashes to earth and loses half its value, your portfolio won't be overly harmed.

For example
A good example comes from the small caps I've bought in the past several months from Tom Gardner's recommendations in Hidden Gems. I bought Buffalo Wild Wings (Nasdaq: BWLD), Cutter & Buck, and (Nasdaq: CTRP). Cutter & Buck, a "Tiny Gems" micro-cap recommendation, was down 25% for me before a Swedish firm bought it out. However, I'm also sitting on current gains of 43% in Buffalo Wild Wings and 213% in Ctrip. If we assume (for simplicity's sake) a $2,000 investment in each, my $6,000 would have turned into $10,620: a nice 77% gain, despite Cutter & Buck's "quarter haircut."

Of course, larger companies can be volatile and burn you as well. Supposed "sure things" like JDSU (Nasdaq: JDSU) and RF Micro Devices (Nasdaq: RFMD) lost more than 90% in the great Tech Wreck of 2000. Even Texas Instruments (NYSE: TXN) shed more than 50% of its value during that period. Each of these still has recovered a mere fraction of their value. But you must be especially on your guard with small caps.

How to get small
Despite the risks, the promise is there -- and we actively encourage you to make small caps a part of your portfolio, especially if you have a few years to go before retirement. If you need help separating the wheat from the chaff, and want to find out which five small companies our team likes for new money, consider a trial run with Hidden Gems. After four years, their recommendations are beating the S&P 500 by an average of 19 percentage points. If you're interested, here's more information on a no-risk, free trial.

This article was originally published on Dec. 5, 2006. It has been updated.

Rex Moore is an analyst for Stock Advisor. He owns shares of Buffalo Wild Wings and NVIDIA is a Stock Advisor recommendation. Buffalo Wild Wings and are Hidden Gems picks. The Fool also owns shares of Buffalo Wild Wings. This information is brought to you by the Fool's disclosure policy.