(MONEY Magazine) – Funds that invest in small-company stocks have lately been giving investors more thrills and chills than Six Flags' Great American Scream Machine. Between October and January, the average small-cap fund rocketed to a 13.8% gain, compared with only 8.6% for the average equity fund. That was promptly followed by a 4.9% plunge in a single mid-February week, as stocks sold off on fears that President Clinton's economic proposals would snuff out the recovery. Small-cap investors, who had been pouring cash into the funds at an average rate of $336 million every week, abruptly pulled $34 million out. While the February gyrations may have rattled fund buyers, fund pros argue that the long-term case for small-stock funds remains unshaken. Little stocks tend alternately to lag and outpace big companies in four- to six-year stretches. As of this year, small stocks have outperformed large stocks for less than 2 1/2 years and are still trading at low prices compared with blue chips. ''Small stocks should continue to beat large stocks by two to four percentage points annually for the next couple of years or so,'' says Ken Gregory, editor of No-Load Fund Analyst ($169 a year; 800-776-9555).

It figures to be a bumpy ride, however. Small-stock funds are prone to pratfalls of 10% or so, particularly after a period of sturdy performance. To cushion the shock of these inevitable downturns, don't put more than 25% of your equity money in small-cappers and don't buy any shares unless you're prepared to stay invested at least three years. You can further safeguard your peace of mind by choosing your small-stock funds with an eye toward capital preservation. The five top-returning funds in the table below have held up much better than their peers in previous market setbacks. Their risk of loss, as measured by mutual fund rating firm Morningstar Inc., runs at least 15% lower than the typical stock fund and 27% lower than the average small-company stock fund. The managers of two of our safety-conscious small-cappers, $1 billion Pennsylvania Mutual and $750 million Nicholas II, are value investors: They look for shares selling at bargain prices and then wait for the rest of the market to recognize the stocks' hidden worth. Says David Nicholas, 31, manager of Nicholas II: ''In the small-cap sector we can find companies with quality management that Wall Street hasn't yet discovered.'' Gary Haubold, 36, and Jim Engle, 34, managers of $53 million Winthrop Focus-Aggressive Growth, are also value investors -- with a twist. They buy stocks that are out of favor but only when the company's business shows signs of improving. ''We may miss the lowest price,'' says Haubold, ''but we also avoid the losers that repeatedly turn in disappointing earnings.'' Our other two choices, $1.3 billion Fidelity OTC and $14 million Fasciano, prefer stocks with an established record of strong earnings growth. But their managers avoid shares trading at price/earnings multiples far above the companies' annual growth rate, since such issues tend to be pounded if their growth falters even for a quarter. ''I stay away from nosebleed territory,'' says Fidelity manager Alan Radlo, 35, who has recently been buying fallen health-care companies. Michael Fasciano, 37, manager of the fund bearing his name, looks for companies with consistent annual growth of 15% or more and lower-than-average P/Es. One caution: 6% of fund assets are in one holding, consumer lender Mercury Finance Co. Another fund worth considering is too new to be included in our table: two- month-old Mutual Discovery (no load; up 8.9% so far this year; 800-448-3863), run by well-known value investor Michael Price, 42. Two of Discovery's stablemates are Mutual Shares and Mutual Qualified, which last year gained an average of 22.3%. Discovery differs from its siblings only in focusing on foreign and domestic companies with market values under $500 million. Price has announced that the fund, now at $111 million in assets, will close when it reaches $300 million. So if you're interested, don't wait.

CHART: NOT AVAILABLE CREDIT: Sources: Lipper Analytical Services and Morningstar Inc. CAPTION: FIVE SMALL-STOCK FUNDS THAT TAKE LOW RISKS To invest in small stocks without taking giant risks, take a look at these portfolios. Their risk levels range between 65% and 85% of the average equity fund's. All attempt to minimize their vulnerability to market downturns by leaning toward less volatile low-P/E stocks and by holding at least 40 different stocks from a wide variety of industries.