Investors saving for retirement-still reeling from the trauma they've endured over the past year-are understandably looking for safety and averse to anything labeled as "risky."

So where exactly does that leave small-cap equities?

If you go by the traditional view, small-cap companies are riskier plays than their mid- and large-cap counterparts and, therefore, an asset class category that should be viewed warily.

Small caps can provide a higher upside, but as a whole, the group consists of thousands of fragile and under-researched companies that are extremely sensitive to changes in the marketplace and the economy. This point was hammered home in 2007, when small caps were the first to plummet as the subprime mortgage meltdown cascaded into a full-blown recession.

At a time when investors and their advisors are trying to safeguard what's left of their retirement accounts, investing in small caps would seem like a lot of risk to swallow. But market watchers say investors would be wise to do just that.

Take them or leave them, small-cap companies remain an integral part of the economy-some say its most dynamic part-and should have some representation in a well-diversified retirement portfolio, experts say.

Money managers also note that all equities hold risks and, over the long run, small caps have historically outperformed large caps. They also note that small caps, while the first to fall at the start of a recession, are typically the best performers as the economy goes into a recovery.

"They represent a vital part of our economy," says Whitney George, co-chief investment officer with The Royce Funds, a 37-year-old shop that specializes in small-cap value investing. "It's where new innovation is found, new business models and new products."

Small caps typically grow faster than larger companies, he says, noting that most big companies started out as a small cap. "They comprise a pretty broad space between a venture capital idea and when something gets into the S&P 500," he says.

One of the riskier aspects of small-cap companies-the lack of analysis and reporting by Wall Street-also stands out as one of their benefits, argues Jim Roumell, president of Roumell Asset Management in Washington, D.C.

"There are fewer things on the planet more vigorously marketed than common stocks. Wall Street is literally pumping up stocks day in and day out," he says.

That leads to more liquidity and marketability, but also artificially inflates expectations and prices. In the less-well-known universe of small caps, he argues, investors get a more efficient market. "If companies ultimately put up numbers and perform, their prices will reflect that," Roumell says.

These are among the reasons why, for those who want to build a portfolio that emulates the entire market, small caps are almost a mandatory part of a diversified portfolio.

Target-date mutual funds-the "set-and-forget" products that are designed as risk-managed retirement savings solutions for individual investors-typically devote a percentage of their equity allocations to small caps. At T. Rowe Price, one of the leading target-date fund providers, small-cap equities currently represent about 11% of domestic equity allocations, according to Ned Notzon, chairman of T. Rowe Price's asset allocation committee.

That represents a slight underweighting, he notes, due to the run-up in small-cap values in the recent market rally and a favorable outlook for large caps. "Going forward, the large-cap stocks will probably benefit more if the global economy improves," he says.
At ING Investment Management, a small-cap allocation makes up a portion of the firm's target-date funds until the investor's retirement, when they are phased out, says Seth Finkelstein, a portfolio manager on ING's multi-asset strategies team. The company's 2045 target-date fund, for example, devotes 95% of its allocations to equities, of which 10% is small cap. By comparison, large caps make up 44% of the equity allocations and international is 21%.

While ING expects small caps to outperform large caps over the long term, the spread between the two categories may tighten, Finkelstein says. Over the next seven to ten years, ING expects small caps to bring an annualized return of 10.5%, while large caps bring in 9.5%.

This tightening is largely due to the expansion of the global economy, he says. "We anticipate a weak dollar and higher exports, which favors large-cap companies given that they do have more exports and revenue," he says.

Small-cap allocations in a retirement portfolio should vary, depending on factors such as an investor's total assets and investment horizon, says Bridget Hughes, an associate director of fund analysis at Morningstar.

Historical data show that small caps, particularly small-cap value, outperform larger-capitalization categories over a long period of time, she notes.

This has been the case in recent years. Over the past ten years-a period of time some have labeled "The Lost Decade" for market investors-the Russell 2000 value index has brought an annualized return of 6.4%. That beats all other asset class categories, including the large-cap Russell 1000, whose annualized return is down 0.72% for the period.

"There is this expectation that you are going to get higher returns for the extra risk," Hughes says. "So I think there are arguments for including smaller companies in your portfolio when you have a long time frame."

Investors, she says, need to be aware of the risks and diversify their holdings. Small caps, for example, carry some extra risk nowadays because one of the category's largest sectors is the financial industry.

Small caps, by their nature, tend to be sensitive to changes in their respective marketplaces and the general economy, she says. "Many of them have very non-diversified revenue streams, so they may be vulnerable to a downturn, but also levered operationally to an economic upswing. It just sort of magnifies the effect of the economy."

Likewise, changes in the credit market can hurt small-cap share prices more than those of larger-cap companies, she says. "On the flip side, when the purse strings loosen up, that can really be a big springboard for them."

For these reasons, advisors say they continue to use small caps as a basic building block in their client portfolios. "We certainly feel that small caps, even in this environment, have a place in portfolios-even for retirement planning," says Ekta Patel, managing advisor at Altfest Personal Wealth in New York.

For a 35-year-old client at her firm with a retirement portfolio invested mostly in equities, small caps would typically make up 10% to 15% of allocations, she says. Because of the resources required to carry out due diligence on small-cap companies, Altfest does not allocate any client assets to individual companies. Instead, Patel says, the firm relies on diversified small-cap mutual funds.

As a client gets older, the firm's small-cap allocations, along with all its other equity allocations, are drawn down to reduce risk, she says. Whether the small-cap portion remains in the account after the person has retired depends on the client's financial situation.

"I think it becomes zero if you are getting closer to reducing all other safer asset classes," she says. "When you are getting closer to depleting your account, you probably don't want small cap when you want room for bonds."

At SagePoint Financial in San Diego, clients typically have allocations between 5% and 12% in small caps, says Scott Wolters, a principal of the firm. His firm also relies on mutual funds for its allocations, which Wolters says isn't always easy. When the large-cap sector tumbled nine years ago, he says, investors ran to small caps, which prompted many quality funds to close to new investors.

"What we are looking for when we pick different funds is, whenever possible, a manager who has been there at least ten years," he says.

If history is any guide, he says, small caps stand to be top performers if the economy settles into recovery mode this year.

This advantage of small caps for post-recession returns was pointed out in a recent study by Bridgeway Capital Management in Houston. The study found that during a recession, small caps slightly underperformed large caps by a margin of 5.4% to 5.9%.

In looking at the economic recoveries, however, following ten recessions since 1948, small caps were shown to be the dominant performers.

Three months after recessions, for example, small caps had an average return of 9.8%, compared with 6.5% for large caps, according to the study. A year after a recession, the average small-cap return was 24.7% while the return was 17.2% for large caps. After three years, the average small cap was up 60.1%, while the return was 46.3% for large caps. The study also concluded that post-recession returns were even greater for micro-cap and ultra-small-cap companies.

Figures like these have some small-cap managers questioning the conventional wisdom that says small caps are a risky play. "I don't know why that mantra has gained so much credibility," Roumell says. "During any period of time that is needed to invest in the stock market, small outperforms large. On what basis is a diversified small-cap portfolio more risky than a large portfolio?"