Why Aren't You Earning 50% Annual Returns?

Look at the title of this article. Is there any more preposterous question a client or boss could ask an investing professional?

Flip it around. Is there a scarier question for an investing professional to hear from a client or boss?

So you can imagine our surprise/heart-stopping fear when our boss, Fool co-founder Tom Gardner, put us in a room and asked point-blank: "Why aren't you earning 50% annual returns?"

50 what?
To put 50% annual returns in perspective, no money manager anywhere has been able to achieve that degree of success for any meaningful period of time. Perhaps the closest have been Jim Simons of Renaissance Technologies and Joel Greenblatt of Gotham Capital, whose funds reportedly have long-term 40% annual returns.

So where did Tom get his outlandish number? From none other than Warren Buffett.

Of course, Buffett also said he had too much money to manage to prove it. How convenient.

Nuts to that, Tom
But after a few weeks that would have made Elisabeth Kubler-Ross proud, we finally answered the question. And while the answers may not help us earn 50% annual returns (still an outlandish number), they can help us all make more money in the stock market.

Ready to learn more?

Lesson 1: Sell your index fund
There is no surer way to not beat the index than by investing in the index itself. Not exactly a revelation, right? Investing in index funds leads to near-certain long-run underperformance because of transaction costs and management fees.

Given that, what would possess a returns-hungry investor to go that route? While owning an index fund makes sense in many cases, if you're serious about market-beating returns, selling your index fund is step one.

Lesson 2: Don't lose money
The aforementioned Warren Buffett has two rules. Rule No. 1: Don't lose money. Rule No. 2: Never forget Rule No. 1. While we ribbed Buffett above, we also respect him a great deal and believe he is spot-on about losing money.

Losing principal soaks your long-run returns. To illustrate, imagine you've lost 50% of your initial investment on your biggest holding. The next year, it bounces back with a 100% return. Guess what? You're still worse off than if you'd just left that money in a savings account.

Efficient-market believers argue that risk and reward go hand in hand. That's generally true. But there is one obvious alternative path.

Lesson 3: Look where no one else is looking
Let us put this plainly -- you can't achieve anything even remotely close to 50% annual long-term returns by investing in large-cap stocks. Period. Sure, you can best the market in the long run with that approach (and doing so by just a couple of percentage points annually would be a notable triumph), but you won't get to 50% annually.

If you want to work toward that mythical 50% mark, you'll need to consistently crush the market by finding the next home run stock and holding for five years or more. Your best chance is by going small.

Why's that? First, small caps, because of their size, have more upside potential than large caps. Second, because Wall Street players are typically constrained to only looking at large- and mid-cap companies, you can take advantage of pricing inefficiencies.

Just take a look. If you're sticking with just S&P 500-type stocks, you're swimming with sharks:

With small caps, you can get greater reward and you don't have to outwit a horde of Ivy League CFA-types to buy the best ideas.

Ready for 50%?
Let us be clear: You can do just fine financially by saving and investing regularly in an index fund. But if you want to shoot for 50% annual returns, those are three ready-made ways to get started.

Yes, there will be volatility. Yes, they may not get you all the way to 50%. But if you employ the strategy faithfully, you should be able to seriously accelerate your portfolio's growth.

At our Motley Fool Hidden Gems small-cap investing service, we specialize in identifying small, cheap stocks that Wall Street simply isn't willing to look at. Our picks are beating the market by more than 32 percentage points on average, and you can take a look at our top stocks for new money by joining the service free for 30 days. Click here for more information.

This article was first published Sept. 27, 2007. It has been updated. 

Neither Joe nor Tim owns shares of any company mentioned. CEO Tom Gardner also has high expectations for the Fool's disclosure policy.