Investing in small-cap stocks can be an emotional roller coaster, especially in a market like this. 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. Clearly, 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 exchange-traded fund (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 (NAESX), which tracks the broad small-cap market, returned 5% per year over the past 10 years, while the Vanguard S&P 500 Index (VFINX) gained just about nothing over that period.

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

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.

For one thing, the fund could be spreading your investment across too many stocks. The Vanguard Small-Cap Index, for example, holds 1,732 stocks. The fund's top two holdings, SAIC (NYSE:SAI) and Rayonier (NYSE:RYN) each make up just 0.27% of the total portfolio. So, theoretically, for every $1,000 you invest in the fund, only $2.70 goes toward each stock. Even if the stocks double, it won't help your returns much.

Secondly, many small-cap fund holdings lean toward the mid-cap range of $1 billion to $3 billion, which prevents investors from truly benefiting from small-cap exposure. Consider that the average market cap of the Vanguard Small-Cap Index is $1.3 billion, which is closer to 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 does 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 Hansen Natural (NASDAQ:HANS) as an example. One of the best stocks of the past ten years, today it's a $2.6 billion company whose stock is up 3,684% over the past 10 years, stemming from its success with its Monster energy drinks, among other things.

Now, if Hansen were to grow another 3,700% over the next 10 years, it would become roughly a $92 billion company -- comparable to the size of Cisco Systems (NASDAQ:CSCO) and Wells Fargo (NYSE:WFC) today. This isn't to say that Hansen couldn't have continued success, but such high-octane growth gets harder to come by as the company gets larger, and you can bet that competitors such as PepsiCo (NYSE:PEP) and Coca Cola (NYSE:KO) will want a bigger piece of the action for themselves.

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 the market hasn't discovered yet.

They look for companies such as Buffalo Wild Wings, a $375 million buffalo wing/sports-themed restaurant chain that's performed very well despite the recent market turmoil. Moreover, the company is headed by a CEO who owns about 1% of the shares and has a very solid balance sheet with no long-term debt.  

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 owns no shares of any company mentioned, but he does own a complete set of 1990 Fleer baseball cards. The Fool owns shares of Buffalo Wild Wings. SAIC and Coca-Cola are Motley Fool Inside Value selections. Buffalo Wild Wings is a Hidden Gems pick. The Fool's disclosure policy reminds you that only you can prevent forest fires.