Is it wise to diversify with small-cap stocks? Quite simply, yes. However, things are rarely that simple, and to take that answer and run with it without heeding warning or nuance probably would be a huge mistake.

What The Experts Say

I think the market has potential to run higher short term. How short term? I don’t know. (For related reading, see Mastering Short-Term Trading.) Nobody can time the market. However, I believe this bull run is a result of prolonged record-low interest rates, which has led to debt-fueled growth. When interest rates increase and those debts become more expensive, I think stocks will suffer. Keep in mind that roughly $17 trillion in government debt and $45 trillion in private debt needs to be unwound. The economy can’t grow organically and sustainably when massive debts need to be repaid — a higher percentage of available capital will have to go toward debt repayment rather than being reinvested in the business. (For related reading, see: Market Timing Tips & Rules Every Investor Should Know.)

Interesting, perhaps, but that’s not the scary part. The scary part is that Warren Buffett, Bill Gates, and Bill Gross have all made bearish comments to CNBC recently about the state of stocks and bonds. You might say this isn’t as much the case for Buffett, but that’s only if you fail to read between the lines.

According to Buffett, if interest rates remained low for five to 10 years, stocks would be extremely cheap right now; if interest rates increased, they would be overvalued. If you consider this comment below the surface, it simply means that stocks are overvalued. The only way that wouldn’t be the case is if interest rates remained low perpetually. (For related reading, see: Why Didn't Quantitative Easing Lead to Hyperinflation?)

Gates was more direct, stating that low rates pose leverage and bubble risks. And Gross said that the supercycle for stocks and bonds is coming to an end.

Future of Small-Cap Stocks

So, how does all this apply to small-cap stocks? Over the past six years, the majority of small-cap stocks have performed well. This makes sense because higher-risk/speculative stocks outperform in bull markets. Look at small-cap biotech stocks over the past year as an example. (For related reading, see: 4 Ways Galena Biopharma Could Disappoint Investors.) When the market reverses, many of those small-cap stocks that rode the wave will have to fend for themselves. In other words, they will have to be proven businesses with significant upside potential if they’re going to see sustainable stock appreciation. (For related reading, see: Top Small-Cap Stocks for 2015.)

Given these circumstances, you can’t just buy a mutual fund or exchange-traded fund (ETF) with a lot of small-cap exposure and expect good things to happen for years to come. As you read this, we're in the midst of a changing economic environment. I could post a colorful chart showing you how well small-caps have performed over the past 30 years (they have outperformed large-caps), but that would be senseless and misguided since the next 30 years will look nothing like the last 30 years. (For related reading, see: Does Investing in Small-Cap Stocks Have Advantages over Investing in Big-Cap Stocks?)

How to Play Small-Caps

It’s not all bad news. The right small-cap stocks have potential to be multi-baggers. It’s just that finding them will require a lot more work than in the past. If you’re going to give it a go, the first rule is read the company’s SEC filings. Don’t rely solely on press releases. This is a common error because a company can sugarcoat a press release. By law, the company must report the facts to the SEC. (For more, see: Speed Read SEC Filings for Hot Stock Picks.)

The next step is to see if there’s top-line and bottom-line growth. If the company is losing money but the losses are narrowing, that can be a positive sign. While investing in companies that lose money is very high risk, the potential is extraordinarily high if that company begins turning profits.

Also be sure to go beyond where the average investor will look. For example, visit glassdoor.com to see anonymous employee reviews. Not only will this give you an inside look at company culture and leadership, but sometimes these reviewers unintentionally (or intentionally) drop important hints about what’s taking place on the inside.

Don’t forget to check the company’s website. Does it have a professional appearance? Is the content free of grammatical errors? Do all the pages work? Is there contact information? If so, test it. If it’s a company that partially (or wholly) relies on online traffic, then check its Alexa ranking. How does the site rank globally and domestically? Are they seeing traffic increases or declines? Are people staying on the site longer and viewing more pages?

From there, do some research on upper management. Where did they come from? Do they have experience? Were they successful in their last venture(s)? And see if they’re buying a lot of stock in their own company — insider buying a great bullish tell for small-cap stocks. (For more, see: The Basics of Corporate Structure.)

Finally, check the beta on the stock. If it’s high, then you should consider not paying attention to the stock for a long time. Volatility and emotion don’t mix well. One integral key to success when investing in small-cap stocks can be summed up in one word: Patience. (For more, see: How Does Beta Measure a Stock's Market Risk?)

iShares Russell 2000

If you don’t want to do the research, yet you want to invest in small-caps broadly because you think interest rates will remain low and small-cap stocks will continue to fly, then look at the iShares Russell 2000 (IWM).

IWM is an ETF that tracks the Russell 2000 Index, which is made up of small-cap stocks. IWM has assets of $30.92 billion and trades an average of approximately 27 million shares per day. Therefore, it’s highly liquid, which is a big positive. It also has a low expense ratio of 0.20%, and it yields 1.28%. It has appreciated 11.66% over the past 12 months (as of 5/7/15). (For more, see: Strategies To Trade The Russell 2000 Index.)

The annual holdings turnover is 18%. This shows that management makes necessary changes without panicking. This is yet another positive. The downside is that if the market falters, it won’t matter what management does; this ETF will depreciate.

If you’re going to diversify on your own, there’s another unique angle. Bonds are widely seen as overvalued. It doesn’t matter if you talk to Warren Buffett, hedge fund managers, traders, or finance writers. Many of them feel the same way. I mention Buffett because he recently said that he would short 20- and 30-year bonds if he had an easy way to do it. It's very rare for Buffett to talk about shorting anything, so keep this in mind. (For related reading, see: The Complete Guide to Corporate Finance.)

The Bottom Line

In the current economic environment, it’s nearly impossible to find safe and steady returns. You might want to consider allocating some money to cash while being weighted toward large-cap stocks that pay dividends and have proven the be relatively resilient to bear markets. At the same time, you could allocate a small portion of your capital to small-caps that have high potential. If they are sound businesses with strong management and they’re in a growing industry, then the stock eventually should appreciate regardless of how the broader market behaves. (For more, see: Why Small-Caps and Dividends Go Together.)

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