The Only Way to Earn 50% Annual Returns

Think back to the fall of 2007. Happy times, indeed. The market was rising, Lehman Brothers and Bear Stearns still existed, and we were blissfully unaware of the potential danger of weather balloons.

At that time -- perhaps overcome with confidence -- my colleague Joe Magyer and I penned an article asking why you weren't earning 50% annual returns. This, in fact, was a challenge posed to us by Motley Fool CEO and co-founder Tom Gardner, and one we spent some time thinking about because, well, we thought we might be able to pull it off.

The results of our brain strain
Our strategy to achieve this glorious return had three steps:

1. Get out of index funds.
2. Protect our principal.
3. Invest in small, underfollowed stocks that are likely to be mispriced.

Fast-forward to today. While I stand by those three steps, if you had followed them for the past few years, you would have subjected yourself to extraordinary volatility and (at least temporary) losses.

And that's the catch-22: The only way to give yourself a chance at massive returns is to expose your portfolio to massive potential losses. 

So are we idiots?
Since few individual investors are willing or able to take that degree of risk, that two-year-old article looks in hindsight like nothing more than a useless thought experiment. Sorry for wasting your time.

But I've revised my thinking to make it more actionable and relevant to you. Rather than chase 50% annual returns across your entire portfolio, why not aim for them in a small portion of your portfolio. That's called diversification, and it reduces your risk of massive losses. As the same time, as you'll see below, it also gives your portfolio the potential to achieve very meaningful outperformance.

Here's what I mean by that
This past summer I traveled to China on our annual Global Gains research trip, looking for stocks that might double or more over the next three years. (Anything less is generally not worth the hassle of investing in China.) One of the companies we discovered in Inner Mongolia was a small fertilizer company called Yongye International (Nasdaq: YONG  ) .

The stock was cheap, the management team savvy, and the market opportunity enormous. In other words, it looked like a promising investment. (To read more about the investment opportunities in rural China, click here.)

And it turned out to be just that
I made Yongye my top pick from that trip. But it wasn't my only pick. Instead, I placed it within the context of a broader basket of plays on the booming development taking place in rural China. In fact, I told folks to buy four stocks in addition to Yongye, with Yongye representing less than half of a full 5% position. Here's what that basked looked like in the end:

Company

Recommended Position Size

Yongye International

2.00%

China Green Agriculture (AMEX: CGA  )

1.00%

China Marine Food (AMEX: CMFO  )

0.50%

Coca-Cola (NYSE: KO  )

0.75%

China Mobile (NYSE: CHL  )

0.75%

And here's what the returns have been from that basket since we recommended it in July:

Company

Return

Yongye

185%

China Green

63%

China Marine

13%

Coca-Cola

11%

China Mobile

0%

As you might guess, the basket has been an incredible performer thus far. In fact, if you weighted the stocks as we recommended, your basket of China stocks is up 90%.

Still, keep it small
Now, it's easy to look at those returns and say that we should have told folks to invest more money in Yongye. But doing so would have subjected you to all of the risks associated with investing in a small, unproven Chinese company -- the consequences of which can be disastrous, given China's "developing" standards for corporate governance and accounting.

Yet you didn't need to invest a ton of money in Yongye to realize significant tangible benefits. In fact, if you were 95% invested in a market index fund composed of stalwarts such as Microsoft (Nasdaq: MSFT  ) and ExxonMobil (NYSE: XOM  ) , and just 5% invested in our basket (as we recommended), then you would have beaten the market's return since July by almost 400 basis points -- 15.5% to 11.6%.

Nothing to shake a stick at
That's a significant improvement that could have been achieved without subjecting your portfolio to enormous potential losses or the volatility associated with emerging markets stocks. Furthermore, thanks to the benefits of compounding, if we can keep that edge up over time through smart emerging-markets investments, the difference in dollar terms on a sum as small as $5,000 becomes incredible.

Year

5

10

20

$5,000 at 11.6% becomes...

$8,650

$15,000

$45,000

$5,000 at 15.5% becomes...

$10,275

$21,100

$89,500

That extra edge is what we seek to deliver to you at Motley Fool Global Gains, through our research trips to emerging markets and careful selection of emerging-market stocks. And as you can see above, the information we provide can make a real difference to your portfolio, even if you're willing to devote no more than 5% to this promising market segment. (Of course, we believe you should devote much more).

But before you decide how much money to devote to emerging markets in your own portfolio, take a moment to read about the stocks we're recommending today at Global Gains. Just click here to take advantage of a free one-month guest membership (a $25 value) -- something we're happy to provide, because we think more Americans need exposure to the world's most promising emerging markets.

Tim Hanson is co-advisor of Motley Fool Global Gains. He owns shares of Yongye International and China Marine Food. China Marine Food and China Green Agriculture are Motley Fool Global Gains recommendations. Microsoft and Coca-Cola are Inside Value picks. The Fool has a disclosure policy.


Read/Post Comments (15) | Recommend This Article (90)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On October 19, 2009, at 5:30 PM, 7footmoose wrote:

    if you think you need to be concerned about accounting transparency with US based companies imagine the complexity of investing in emerging markets, this is for experts only

  • Report this Comment On October 19, 2009, at 6:38 PM, ranger2001 wrote:

    looking 5 - 20 years ahead in your projections for an iffy China stock is irrational

  • Report this Comment On October 19, 2009, at 6:56 PM, Mary953 wrote:

    You have described the situation I try for in my own portfolio. One portion is high risk, hopefully high reward, One portion is gold, silver, cash, hedging for the just in case sort of crash. The majority by far though is the small set of good solid dividend companies that I believe will continue to survive, thrive, and pay dividends. My approach is dictated by the fact that I do not want to have to rebuild - I would rather be closer to retirement in a few years. If I had plenty of time to tackle the possibilites of rebuilding lost income, I would have a larger stake in those high risk, high reward stocks.

  • Report this Comment On October 19, 2009, at 8:13 PM, jlevando wrote:

    tim,

    what kind of nimrod are you to tell your prudent investors to not utilize an incredbily profitable, low internal cost, index (ie ETF) fund. there is noone out there who can say they chase individual equities and achieve 50% annual returns. Conversely, I have emerging ETF/mutual funds (eg, ILF, EUROX, GMF, JAOSX, PRLAX, VWO) all way in excess of 50%.

    In all your stock picking prowess, what do you then recommend??????????

  • Report this Comment On October 19, 2009, at 11:25 PM, ETFsRule wrote:

    I've got to agree with jlevando. A lot of these new ETFs are simply great. Great, great, great.

    Here are some of my personal favorites: EWZ, BRF, HAO, VNM, IDX, IF, DGS, GXG. Just take a look at any of them, compare them to the S&P, and I think you'll be convinced.

    In the past, investors often had to choose between diversification (via mutual funds), or high returns (via individual stocks). Now with these ETFs, you no longer have to choose... you can have it all! You don't even need to be a good stock picker... just buy these ETFs and get rich! It's sooooooo easy. Maybe that's why the Motley Fool doesn't want to tell people about them?!

  • Report this Comment On October 19, 2009, at 11:59 PM, john795806 wrote:

    In defense of Motley Fool, they do occasionally recommend ETFs. I got a free recommendation off of their site for EEB. It is up 20% since I bought it 2 months ago, soundly spanking the S&P.

  • Report this Comment On October 20, 2009, at 8:30 AM, bucheron wrote:

    All on Black once a year :))

  • Report this Comment On October 20, 2009, at 8:43 AM, bucheron wrote:

    No but seriously,

    I'm not sure if Tim Hanson meant not to use ETF, but I prefer not to use them for the simple fact that they cover a broad market including stocks that are overvalued and risky.

    Why not buy 8-10 undervalued stocks of small companies of different sectors and regions and keep them for couple years? I think most people don't want to take the risk and look like the fool and are not sure how to go about it so they just take the easier way and buy ETF, which is fine with me takes a lot of players out of the market to find that small undervalued company that most investors haven't looked at.

  • Report this Comment On October 20, 2009, at 10:10 AM, 123spot wrote:

    Tim, What about this 25 million share offering this am. bought in yesterday and YONG falling like a rock ? on this news or? on the "restructuring" announcement. Please advise or update. Thanks.

  • Report this Comment On October 23, 2009, at 3:32 PM, Archvile wrote:

    It is an easier choice for most people to buy into funds and ETFs because there is more rick in buying individual stocks and more importantly , it is difficult to find undervalued stocks. There are lot of metrics that go into deciding what 'undervalued' actually means. Lot of people, I think,

    1. are scared to understand terms like P/E and book value and EPS increase and

    2. then apply them to, literally, thousands of stocks, and come up with 7-8 that are investment worthy.

    It is hard to believe but in my opinion, most people make 'investments' based on what they hear or read and not on their personal DD.

    Anycase, I am vested in some chinese caps myself CHCG.ob, UTA, GIGM (NOT strictly chinese). 2 out of 3 have tanked one has doubled.

  • Report this Comment On October 23, 2009, at 6:28 PM, salvadorveiga wrote:

    geeez... just follow the trend guys !!!!

    I could tell you how much i'm up just by following a trend following technical system... I not only avoided the 2008 crash, but altogether I profited handsomely from it...

    Trends is the best approach to investing... undervalued companies?? The value that a company has is what the market pays for it at that moment...

    I ask how many did take advantage of such charts:

    <img src=http://3.bp.blogspot.com/_l3Np4NrEMCU/SuItlYFhcII/AAAAAAAAAk...

  • Report this Comment On October 23, 2009, at 6:28 PM, salvadorveiga wrote:
  • Report this Comment On October 23, 2009, at 6:29 PM, salvadorveiga wrote:

    just follow the trend...

    more at www.mybullmarket.org which i update frequently

  • Report this Comment On October 23, 2009, at 7:04 PM, jtryan wrote:

    you can get close to 50% on almost any etf selling naked puts and then when assigned selling covered calls check it out

  • Report this Comment On October 25, 2009, at 10:04 AM, Muhammad4M wrote:

    Absolutely trend following is the reason i made handsome returns last year and this year-your exits and money management make the smart money not predictions.

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