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3 Ways to Make Small Stocks Pay

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Small stocks' luster could soon fade.

It’s hard not to get stars in your eyes when it comes to small stocks.

Shares of small companies, after all, have historically outpaced blue chips by around two percentage points a year. And over the past 15 years, stocks with market values of less than $3 billion have doubled the returns of the Standard & Poor’s 500.

Plus there’s the greed factor: the hope that you’ll spot the next eBay or Amazon.com before everyone else sees it. Alas, the chances of doing that—or finding the same level of success in small stocks that you enjoyed in the recent past—are a lot slimmer than you might think. Here are three ways to be smart about going small.

Set Your Sights Lower

If the late ’90s bubble in big tech and drug stocks taught you anything, it’s that the price you pay for a stock directly affects your future gains. Well, 15 years later, small equities have risen into bubbly territory.

Earlier this year, their price/earnings ratio, based on five years of median profits, hit 30 for just the second time ever. The other occasion was in 1997, before small stocks went into a tailspin. And since small shares peaked in March, they’ve fallen 5%.

They’re still overpriced, though, trading at a 30% premium to their historical valuations. “We wouldn’t be surprised if small-caps generate a total return of only 3% to 4% a year before inflation over the next seven to 10 years,” says Doug Ramsey, chief investment officer of the Leuthold Group.

Don’t Chase Shooting Stars

T. Rowe Price looked at data for the past 20 years, keying in on small stocks that gained an annualized 20% or more over a full decade. Over any 10-year rolling period in that time, only about 10 stocks, on average, hit the 20% mark. And the average winner slumped more than 27% somewhere along the way. So even if you can spot the next Amazon, ask yourself: Will you have the fortitude to hang on?

Cut Your Exposure

You need small stocks for diversification, but this is not the time to go big. Small caps make up about 10% of the market’s total value, so if you own more, start trimming.

As for the long term, play it smart. Go with funds that focus on looking for undervalued businesses, such as Money 50 member Vanguard Small Cap Value ETF . And exercise patience: Small-stock funds that trade frequently gained 7.6% a year over the past decade; buy-and-hold funds gained 9.3%. Wasatch Core Growth, for one, hangs on to stocks about five times longer than the average fund. Even over the past five years when small stock prices were racy, these two low-key portfolios beat most of their peers.