In the January 2, 2007, issue of Financially Fit, we covered an essential aspect of financial planning: Developing a budget (controlling your expenses) and paying yourself first (saving and investing).

If you have completed that very important task, you should now have a very good idea of the amount of money you can invest in 2007, so let's move on to the next step: Maximizing your investment returns.

Several times in the pages of Financially Fit, we've discussed the importance of diversification: Spreading your assets among different classes and sectors of investments, as well as in investments with various market capitalizations, in order to minimize your portfolio risk. And while most investors realize that proper diversification will definitely reduce the volatility (and risk) of your portfolio, many don't understand that it can also substantially boost your returns.

How? By adding in one class of investments that scares the pants off many investors - small-cap stocks.

Before we go further, let's define what a small-cap stock is. First of all, when I say capitalization, I mean market capitalization - simply the number of shares outstanding multiplied by the current price per share.

Wall Street generally defines the various categories of market cap as follows:

• Large caps: greater than $5 billion
• Mid caps: $1-$5 billion
• Small caps: less than $1 billion, which also includes the following categories:
  • Micro caps: less than $100 million
  • Nano caps: less than $50 million

When investors hear "small cap," it usually conjures up three words: Risk, loss or excitement.

Risk and loss: Certainly, small-cap investing can be risky. Many small-cap companies are the new kids on the block, with unproven products and/or little in the way of earnings and revenue track records. And they come with additional concerns:

• Small caps generally trade at low volumes, as compared with higher-capitalization companies. That means there may come a time when you will not easily be able to find a buyer for the shares you are selling.

• Finding accurate quotes may at times be difficult. For the majority of the small caps you should be buying (I'll have more on this in a later issue), this won't be a problem. But if you are buying and selling micro- or nano-caps, you may encounter this challenge.

• Strong potential for fraud. Again, this most likely won't be a problem unless you are buying some of the smallest of the small-cap companies. However, you should be aware that this potential exists and exercise due caution. One particular area rife with fraud and hype is the bulletin board chat room.

Bulletin boards can be fabulous opportunities for investors to share ideas.

However, you really do not know the players. While many participants will be legitimate investors, countless sleazy stock promoters also frequent these boards, hyping their companies. As unsuspecting investors bid shares higher, the unscrupulous promoters will then pull the rug out by selling their shares, leaving the investors holding shares that plummet.

Another area to watch: Brokers who cold-calling with "the next best thing," ready to make you "millions." Beware, beware, beware! These people are peddling very speculative stocks destined to make money, alright, but only for them!

Excitement:

Yes, the potential to make a killing is there! But windfall profits are rare, and the potential to lose your hide is much greater - especially in the very small speculative issues. That being said, however, if you exercise the same caution and good investment practices - including a thorough analysis of the company - that you do when you buy any other stock, small-cap stocks do hold the potential to significantly add to your portfolio returns.

But, don't just take my word for it:

According to a study by Morningstar, a $10,000 investment made in large-cap stocks at the end of 1975 would have grown to $317,004 at the end of 2005. That same $10,000 invested in a portfolio of 70% large-cap and 30% small- and mid-cap stocks would be worth $440,146, but an investment in 40% large-cap and 60% small- and mid-cap stocks would have grown to $572,899.

 Total return for stocks in that 30-year time period was as follows: Small caps (88.5%); mid caps (65.3%); and large caps (32.7%).

For further proof of small-caps' advantageous returns, take a look at the 80 years worth of research by Professor Ken French, from the Tuck School of Business at Dartmouth:

From 1926 through 2006, small caps returned an average of 13%, annually, compared to the 10% returns of the stocks in the S&P 500 index.

Certainly, there are cycles of good and bad years. Small caps do especially well in periods of high economic growth, when their shares return an average of 16% per year, compared to 11% for large-cap stocks. Conversely, during recessionary periods, small caps have averaged a decline of 10% annually, versus just 3% for their larger-cap brethren. Fortunately, since 1926, the economy has grown in 64 years, with recessions only in 15 years.

And in the years when the economy was neither growing like the weeds in my garden, nor languishing in a severe economic slowdown, small caps held their own.

That should leave you with one conclusion: Small-cap stocks should be a part of every investor's portfolio.

In the next few weeks, I will be bringing you some specific ideas on how to add small caps to your portfolio to help you increase your returns and reduce your risk.