Micro-cap Stocks are much maligned for being too volatile for the average investor. But, as experienced investors know, highly volatile investments can yield the best investment returns. A quick look at the best-performing stocks of 2005 proves this fact.

The Best Stocks of 2005 Were All Micro-caps

Of the 25 stocks that performed best in 2005, only Nutri/System (NTRI) had a market cap of $100 million at the start of the year. Ocean West Holding (OWHC), which was up an astounding 2,170% for calendar year 2005, ended the year with a mere $59 million market cap (that's after returning 2700%).

To be sure, micro-caps are volatile, (Ocean West is down over 50% after the first quarter of 2006, erasing most of 2005s incredible gains), but the potential returns still make them a worthwhile risk for a small portion of your investment portfolio.

Of the 25 top-performing stocks of 2005, all of which returned at least 510%, 13 were down as of this writing (April 15, 2006), and 12 were up. The average stock that was down had lost 19.93%, which represents about one-quarter of its 2005 gains.

Of the 12 stocks that were up in the Year-to-Date period, the average return was 88.68%. Half of those stocks had already returned over 100% returns (CanWest Petroleum; U.S. Gold; BioTransplant; Warrior Energy Service; Stem Cell Innovations; and Transnational Automotive Group).

An equal investment in all 25 of these stocks on January 1, 2006 would have yielded a 32.20% return by April 15.

Dont Let Your Guard Down

Much of the criticisms of micro-caps are true: they are highly volatile; they are potentially the targets of pump-and-dump schemes; they can be difficult to liquidate due to low trading volume.

For these reasons, due diligence is extremely important. A company whose SEC filings are habitually late, or one that issues amendment after amendment for important filings like the quarterly or annual reports is usually not a solid investment.

But these are just red flags, and the companys fundamentals are the ultimate arbiter of its worth. In times of rising interest rates, the balance sheet is particularly important, since high levels of long-term debt can cripple small companies as rates rise.

Finally, micro-caps should not represent more than 10% of any individual portfolio, but ignoring these tiny gems will deprive investors of potential breakouts.