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Why Aren't You Earning 50% Annual Returns?

http://www.fool.com/investing/small-cap/2010/03/02/why-arent-you-earning-50-annual-returns.aspx

Joe Magyer and Tim Hanson
March 2, 2010

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

Now 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, understand that 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. Their 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 could be done. 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 although 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 nearly certain long-run underperformance, because of transaction costs and management fees.

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

Lesson 2: Don't lose money
Buffett has two rules. Rule No. 1: Don't lose money. Rule No. 2: Never forget Rule No. 1. We ribbed Buffett above, but we respect him a great deal, and we believe he's spot-on about losing money.

Losing principal soaks your long-run returns. 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 do. Second, because Wall Street players are typically constrained to looking only at large- and mid-cap companies, you can take advantage of pricing inefficiencies.

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

Company

Market Cap

Number of Analysts Covering

Motorola (NYSE: MOT  )

$15 billion

35

Amgen (Nasdaq: AMGN  )

$57 billion

24

Diamond Offshore (NYSE: DO  )

$12 billion

35

Citigroup (NYSE: C  )

$96 billion

21