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 Conan O'Brien still had a job at NBC.

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 chasing 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.

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 basket looked like in the end:

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

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 more than 70%. Even better, it's crushed its China benchmarks, such as the Xinhua 25. That passive index, composed of giants such as Sinopec (NYSE:SNP) and Chinalco (NYSE:ACH), is actually breakeven over the same period of time.

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 or China Green. 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 Hewlett-Packard (NYSE:HPQ), Intel (NASDAQ:INTC), and Oracle (NASDAQ:ORCL), and just 5% invested in our basket (as we recommended), then you would have beaten the market's return since July by almost 300 basis points -- 19.3% to 16.6%.

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-market stocks. Furthermore, thanks to the benefits of compounding, if we can keep that edge up over time through smart emerging-market investments, the difference in dollar terms on a sum as small as $5,000 becomes incredible.

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.

The reason I mention this is because we just returned from a research trip to India with our top picks in that emerging market and we're hopeful that they will replicate the success we had in China this summer. Read all about them by clicking here to join Global Gains free for 30 days.

This article was first published Oct. 19, 2009. It has been updated.

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. Coca-Cola and Intel are Inside Value selections. Coca-Cola is also an Income Investor choice. The Fool has a disclosure policy.