As we wrote a year ago, history shows that over long periods of time, the stocks of small companies have outperformed those of large ones. Small-cap stocks are one of the basic building blocks of our Ultimate Buy-and-Hold Strategy, and we think some small-cap exposure makes sense for most investors.

First, a quick refresher from last year’s article. (For the full text, click here.) We won’t repeat the rationale for small-cap investing, because you’ll find it there. But we’ll look again at the strategy we outlined.

It’s important to emphasize at the outset that there are two essential keys to small-cap investing.

First, don’t expect superior results quickly. These funds are suitable only for investors with long time horizons, say a decade or more. They may pay off sooner than that, but they may underperform for very long periods. If you think I’m kidding, consider this: From 1970 through 1998, small-cap U.S. stocks underperformed large-cap U.S. stocks.

Second, make small-cap investing only part of your equity portfolio. Own large-cap stocks, too, and diversify your portfolio between U.S. and international funds.

The topic today is not small-cap investing vs. large-cap investing. I’m assuming that you’ve determined some part of your portfolio should be in small-cap stocks. Today’s topic is your choice between – or your mix of – U.S. small-cap funds and international small-cap funds.

A year ago we showed the year-by-year returns (1970 through 1997) of U.S. and international small-cap stock indexes in the table below. The data is from Dimensional Fund Advisors. We’ve added the 1998 numbers and we now have 29 years of cumulative data. To understand the table, you have to know the meaning of those Options, numbered 1 through 5.

Option 1: Invest exclusively in U.S. small-cap stocks and ignore international small-cap issues. This has the advantage of supreme simplicity, and until last year, this strategy outperformed the Standard & Poor's 500 Index. But last year’s underperformance, a loss of 7.3 percent, finally put U.S. small-caps behind in the race, if there was one, against the U.S. big caps. Over 29 years, this strategy brought you less return (compound rate of return, or CRR) than the Standard & Poor's 500 Index, along with significantly more risk, as measured by standard deviation (STD). This is not the best small-cap strategy.

Option 2: The same as Option 1, except it calls for investing exclusively in international small-cap funds, ignoring domestic ones. It’s simple, and it produced a much higher return over 29 years than Option 1. That return came at the expense, however, of significantly higher volatility – the highest of any strategy we outline here.

Option 3: A very nice marriage of U.S. and international small-cap investing. Split your small-cap money equally between U.S. and international funds and rebalance at the start of each year. This gives you most of the CRR of Option 2 with less volatility than either Option 1 or Option 2. This is what we could call our "conservative" recommendation for small-cap investing.

Option 4: This is the most aggressive of our small-cap strategies. To implement it, you put 100 percent of your small-cap money each January into either international funds or U.S. funds, whichever had the higher performance in the year just ended. This blatantly violates an important principle of investing that says you shouldn’t make investment decisions based on recent past performance. We still believe in that principle. But last year when we were studying small-cap returns, we noticed a pattern that you can see in the table if you glance down the column headed Option 4. In the line for each year, we have listed the segment, U.S. or international, that outperformed in the prior year. You will notice that better performance seemed to persist for more than one year at a time. The success seemed to follow a series of trends lasting anywhere from two to seven calendar years. At least in the years shown in this table, there was a better than even statistical chance that whichever sector was the "winner" in one year would be the "winner" in the following year as well. This option presumes an investor was armed with that notion in 1970 and carried it out. The result was a 20.6 percent CRR that turned $1,000 into $229,025 in 29 years. We certainly don’t recommend doing this with the majority of any portfolio, because the patterns may not be similar in the coming years. But for aggressive investors, this is an interesting way to use small-cap stock funds.

Option 5: Here’s a "moderate" version of the strategy we just described. It calls for putting 75 percent of your small-cap money every January into whichever sector was the winner in the previous year and 25 percent into last year’s lagging sector. This way, you aren’t penalized nearly so much in the years (and 1998 was one of them) when the previous year’s better performer becomes the laggard. On the other hand, you won’t get the full benefits when a trend persists. But your standard deviation will be reduced to the level of a 100 percent U.S. small-cap strategy, with a huge increase in your cumulative return. If you look at the cumulative dollar returns, you’ll see this option left the Standard & Poor's 500 Index far back in the dust.

If you’re a small-cap investor, choose one of these options based on your need (or desire) for return, tempered with your tolerance for risk. One reason we have listed the returns each year is so you can see what you would have had to endure in each of these options.

In Option 1, you had to endure four double-digit negative years. Option 2 gave you five such years. But Options 3, 4 and 5 each had only three years with negative returns in double digits. You might also note that a big part of Option 4’s high standard deviation came from its very high positive years. In eight of these 29 years, Option 4 produced gains of 49.9 percent or better.

Toward the bottom of the table, you’ll see a line for 1999. We wish we knew in advance what numbers we’ll put there next year. But of course that’s impossible. Still, if you’re following Option 4 or Option 5 of this strategy, you’ll be interested to see the word "International" on that line. That means that international small-cap stocks did better last year than U.S. ones.

(A somewhat unexpected component of the internationals’ better performance: Japan’s small-cap stock index rose 18 percent last year.)

If you’re following our recommendations for Option 4 or Option 5, it’s time to make a switch at the start of this year, if you haven’t done so already.

To do that, shift either all (Option 4) or 75 percent (Option 5) of your small-cap money into an international fund. Choose one of these two funds in our Model Portfolios. The Freemont International Fund had a gain of 9.3 percent last year. The Founders Passport Fund was up 11.9 percent for the year. Either one would be suitable for a swap for your 1999 small-cap investments.

For U.S. small-cap investments, choose from these four funds in our Model Portfolios: Vanguard Index Small Cap Stock, Fidelity Small Cap Selector, Schwab Small Cap Index and Dreyfus Small Company Value.

One other note about this strategy: Because you may have to sell some or all of your funds every year, it’s best to do this within a tax-sheltered account. Otherwise much of your gains will be eroded by capital gains taxes. Your best bet is a Roth IRA, where your initial investments are made with after-tax dollars. But in the Roth IRA, your profits are never subject to income tax. We hope this strategy will be successful enough that you will have very large profits from these small companies.