By Mike Caggeso
Associate Editor
Money Morning

[Editor's Note: Money Morning Investment Director Keith Fitz-Gerald is the editor of the new Geiger Index trading service. As the whipsaw trading patterns investors have endured this year have shown, the ongoing global financial crisis has changed the investment game forever.

Uncertainty is now the norm and that new reality alone has created a whole set of new rules that will help determine who profits and who loses. Investors who ignore this "New Reality"will struggle, and will find their financial forays to be frustrating and unrewarding. But investors who embrace this change will not only survive - they will thrive. With the Geiger Index, Fitz-Gerald has already isolated these new rules and has unlocked the key to what he refers to as "Golden Age of Wealth Creation" The Geiger Index system allows Fitz-Gerald to predict the price movements of broad indexes, or of individual stocks, with a high degree of certainty. And it's particularly well suited to the kind of market we're all facing right now. Check out our latest report on these new rules, and on this new market environment.]

Right now many investors probably don’t want to shoot for the moon. The global financial crisis gave their portfolios one the fiercest beat downs since the Great Depression, draining investors’ resources and mood for anything but safe investments.

But it’s unfair to associate small-cap investing as moon shooting, especially as the global economy pulls itself back together. Historically, small caps have beaten the socks off blue chips as both emerge from recession.

After the 1973-74 recession, small stocks beat larger ones for the following 10 years. Going back further, to 1932, the year before the Great Depression ended, small cap stocks beat the market for 11 of the following 13 years, CNNMoney reported.

More recently, however, the Russell 2000 Index (the most common benchmark of publicly traded small-cap companies) has gained 40.2% since the market bottomed on March 9. In that span, the blue-chip-weighted S&P 500 has chugged 24.2%

The difference isn’t extraordinary, but institutional investors who pour millions into these companies know the difference between those figures could spell fortunes.

And even on an individual level, you’d be hard-pressed to find an everyday investor unsatisfied with sitting on a 40.2% gain after a year and a half drought.

Small caps rebound faster because they are typically saddled by less debt and have fewer people on their payrolls – making it easier to restructure and regain footing.

Compare that to behemoths like Ford Motor Co. (NYSE: F) and General Motors Corp. (NYSE: GM), which have been reducing overhead, downsizing and streamlining operations for years.

Also, small caps’ operations and revenue streams are more regionally based, whereas a global titan like General Electric Co. (NYSE: GE) has operations all over the world. While a globally diversified business model ensures better overall stability, it also means more vulnerability at a time when the global financial crisis has crippled nearly every economy in the world.

What’s more, a recent study from the Paris-based Organization of Economic Cooperation and Development (OECD) shows that the United States’ economic deterioration is slowing down at a faster rate than Italy, France, England and China.

In Small Caps We Trust

For practical purposes, small caps can be defined as publicly traded companies with a market capitalization between $250 million and $1 billion. But that’s just an approximation, since there is no official definition or internationally accepted market-cap boundary.

Small cap stocks have fewer shareholders than mid-cap ($1 billion to $10 billion) or large-cap companies ($10 billion and up), and their lack of liquidity makes it much easier for the share price to spike, or plunge, with a major shift in trading.

Think of it them as boats in an ocean. The winds and waves will cause a small boat to rock much more than they would a tanker. But a strong current will push a smaller vessel to its destination faster than it would a larger ship.

Investors are attracted to small caps because they can take a larger stake in a company (and usually at a lower entry price) with the expectation that as the company grows – or gets bought out – their small investment will reap a large reward.

And right now – as the economy and stock market rebound from the vicious recession – it’s an especially good time to eye small-cap companies. Small caps have already proven to be the more profitable investment as global economies are licking their wounds.

Of course, there are two things to consider before investing a dollar in small caps.

The first is volatility. Because they companies are vulnerable to shifts in market sentiment, it is not advisable to apportion a large block of your portfolio in small-caps.

Secondly, now may not be the best time to jump in. Those closely watching small caps believe they have overshot their values – meaning a pullback is expected soon, if it’s not happening already.

Small caps stocks have risen 40.2% since March 9, but they are also down 5.9% from their May 8 peak.

“All in all, we think [small-caps] have moved too far, too fast,” Bank of America Merrill Lynch small-cap strategist Steven Desanctis recently wrote to investors.

Desanctis expects the small-cap pullback to continue because small companies’ price-to-earning ratios have moved above average compared to those of larger companies.

Also, analysts expect at least a few more months of market-wide volatility – and the tossing and turning of small caps stocks may not sit well with many investors.

Medium-to long-term though, small caps have proven their profitability, especially when investors amass positions in a recession’s late stages.

Here are six ways to invest in a variety of small cap stocks, should the current pullback present a favorable opportunity.

The iShares Russell 2000 Index ETF (NYSE: IWM) is a fund that tracks the movements of the Russell 2000 Index. The Fund invests in a representative sample of securities included in the index that collectively have an investment profile similar to the index.

The iShares Russell 2000 Value Index ETF (NYSE: IWN) tracks an index that measures the returns of safer, less speculative small-cap stocks. And the iShares Russell 2000 Growth Index ETF (NYSE: IWO) tracks an index that measures the returns of riskier, more growth-oriented small-cap stocks.

Vanguard also has variety of small cap funds, but they track the movements of a different index of small U.S. companies, the MSCI US Small Cap 1750 Index.

The Vanguard Small-Cap ETF (NYSE: VB) tracks the movements of the MSCI US Small Cap 1750 Index not only by amassing a position in nearly every company traded in the index, but attempts to mirror the proportions of those holdings as well.

The Vanguard Small-Cap Value (NYSE: VBR) tracks safer, less speculative small-cap stocks on the index. And the Vanguard Small Cap Growth (NYSE: VBK) goes for more growth-oriented returns on the index.

Last 5 posts by Mike Caggeso

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