In your stock portfolio, size matters.

Most American investors are familiar with the large companies tracked by the Dow Jones industrial average and the Standard & Poor’s 500 index. But fewer people have much knowledge of smaller stocks tracked by indexes such as the Russell 2000 or the S&P SmallCap 600.

Small-cap stocks are typically those with market capitalizations between $300 million and $2 billion. Investors are sometimes surprised to learn that small-cap indexes are home to some well-known companies, such as Dave & Buster’s Entertainment (ticker: PLAY), Angie’s List (ANGI), Land’s End (LE), Papa John’s International (PZZA) and 1-800-Flowers.com (FLWS).

Small caps constitute a fairly modest sliver of the investable U.S. equity universe. For example, the Russell 2000 index represents about 10 percent of the total market capitalization of the Russell 3000, which tracks the broader U.S. stock market.

For more than three decades, researchers have been studying the risk-and-return characteristics of small-cap stocks. While academics continue adding to the body of small-cap knowledge — as well as debating the finer points of the quantitative research — a growing number of asset managers say it’s important to include small caps in a well-diversified portfolio.

Nonetheless, individual investors often shy away from smaller stocks.

There are several reasons for that, says Lamar Villere, co-portfolio manager of the Villere Balanced Fund in New Orleans. Although there are some household names sprinkled among the ranks of small caps, the majority of smaller firms are not well-known outside their own industries.

That lack of familiarity may be a deterrent. “There is a natural tendency to want to invest in companies you’ve heard of, and companies you believe to be safe. Volatility is certainly an investor concern as well. We do a lot of work with our clients to help them focus on the long-term outlook, rather than strictly looking at short-term volatility,” Villere says. “Small caps are also a lot more difficult for a retail investor. There are lots of horror stories about people buying individual small-cap names without doing the intensive due diligence that is needed. It’s certainly easier for someone to buy IBM rather than spend the time to identify tomorrow’s industry leaders.”

Gary Bradshaw, portfolio manager at the Hodges Small Cap Fund in Dallas, also sees reasons investors may not be familiar or comfortable with small-cap investing.

“Small caps do tend to outperform large caps,” he says. “They are often avoided by investors, as many small caps are neglected and not followed by Wall Street analysts. Small caps just don’t have the same investment research coverage as do the large caps. They do have a tendency to be more volatile, as they are younger companies whose earnings and cash flows can be more erratic than larger, more seasoned companies.”

Many investors understand the intellectual argument behind investing: To generate a return, it’s necessary to take risk. But that doesn’t necessarily make it easier to diversify into smaller stocks.

“Small-cap stocks are a great example of high risk, due to the high level of uncertainty about their future returns,” says Mark Hebner, president and founder of Index Fund Advisors in Irvine, California.

Hebner says long-term historical data supports the relationship between company size, risk and return. According to data compiled by Hebner’s firm, the smallest 10 percent of companies delivered an annualized return of about 13.5 percent between 1928 and 2014. Meanwhile, the largest 10 percent of firms realized a 10 percent return.

However, investing in a smaller company is typically riskier than investing in a larger one. To take that additional risk, investors demand to be paid a premium.

“On the flip side of expected return is the cost of capital to the firm. The riskier the firm, the higher the cost of capital to the firm’s shareholders, and the higher the expected return of the investor,” Hebner says.

Bradshaw says small caps often grow their revenue, earnings and cash flow at higher rates than large caps. “Because of the faster growth rate, small caps tend to trade at a higher price-earnings multiple than larger caps, and this often makes small caps more volatile,” he says. “But at the same time, this is a catalyst for small-cap outperformance.”

Hebner includes small stocks in portfolios that are diversified to include different market capitalizations, regions, asset classes and styles, such as value and growth. He uses passively managed funds to achieve that diversification. His clients hold not only stocks of small, U.S.-based companies, but also stocks of small companies headquartered throughout the world, including emerging-market countries.

Villere and Bradshaw, both of whom manage active funds, focus on U.S. companies in their portfolios.

As with every financial decision, potential small-cap investors should understand the risk-and-return trade-offs, the benefits of diversification and their own risk tolerance.

“Small caps aren’t for everyone,” Villere says. “We talk to a lot of clients that absolutely have the resources to handle the volatility, but who know themselves well enough to know that they can’t emotionally handle the volatility. It’s sort of ironic that one of the greatest strengths of the stock market, its liquidity, is exactly what scares off a lot of investors. If someone rang your doorbell every morning and told you that your home’s value had changed by $10,000 or more, you might start to get skittish about homeownership. With stocks, you can watch their value rise and fall just like you can watch your favorite baseball team. It’s hypnotic, but unfortunately leads some to make poor decisions.”

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What Investors Should Know About Small-Cap Stocks originally appeared on usnews.com