Before we start tonight's column, a bit of housekeeping. We've had about $5,375 in cash in the portfolio for more than a month now, following our sale of Excite@Home (Nasdaq: ATHM). We will be sweeping that money into exchange-traded Standard & Poor's Depositary Receipts, affectionately known as Spiders (AMEX: SPY), sometime in the next five days, in accordance with our intention to stay fully invested.

Now, on with today's column.

One of my least-favorite expressions is "You do the math." As in, "100% quarter-to-quarter growth in sales? You do the math!" Which means, "I'm too busy to explain this. Any fool could get it."

Actually, real Fools are not too busy to do the math. They dive in, knowing that successful investing takes nothing more than arithmetic. Thank goodness. The only college "incomplete" I ever received was in my first and only step beyond arithmetic: Calculus. As a result, I know my limits. (Ahem.) I'm very grateful for spreadsheets and calculators, the latter of which just arrived my freshperson year in college. Ah, happy days, when the drinking age was 18... but I digress.

How much do Rule Breakers need to make?
We need some math to see whether our Rule Breaker financial goals make sense. In November, the Rule Breaker Team started discussing 10x/5y -- shorthand for, "Will a proposed Rule Breaker investment earn us 10 times our investment within five years?" To help distinguish among candidate companies that already satisfy Rule Breaker criteria, we ask: Which company do we honestly believe offers the highest potential return to compensate for the enormous risk we accept?

But, is it enough for one of our investments to earn 10 times, 900%, in 5 years, if our others are losing 50% or more? To find out, let's say you and your Foolish friends in the Dinero Grove Investment Club allocate a certain percentage of your portfolio to Rule Breaker stocks, equal to $50,000. After many evenings together and online on the Fool's stock discussion boards (mais oui!), you have identified five true Rule Breakers: 

  • Monster Gene (Ticker: FSTEIN): Designer gene mutations.
  • Stuff Is Us (Ticker: JUNK): Everything, everywhere, all the time, free, online.
  • Miles on Video (Ticker: LOST): Head-mounted videocam captures your route so you can always retrace your steps.
  • Organucopia (Ticker: TPLNT): Unlimited non-rejecting replacement tissue, for a fee.
  • Ret2Phone (Ticker: NOWIRES): Wireless Internet phone communications via a Eustachian tube implant, combined with a wireless, broadband, high-resolution picture wired to your retina. Ick!

In 2001, you plunk $10,000 into each at $20 per share, yielding a hefty 500 shares apiece. At the end of five years, here are the results:

       Purch. #   value  price  value   total
       price shrs. 2001  2006   2006    return
FSTEIN  $20  500 $10,000 $ 10 $  5,000   -50%
JUNK    $20  500 $10,000 $  5 $  2,500   -75%
NOWIRES $20 500 $10,000 $ 2 $ 1,000 -90% LOST $20 500 $10,000 kerplooey! -100% TPLNT $20 500 $10,000 $200 $100,000 +900% TOTAL $50,000 $108,500 +117%

10x/5y versus S&P 500?
Over five years, the Dinero Grove portfolio returns 117%. Sweet! Or is it? Ah, the annual health-club bragging, accompanied by intimidating musculature: "My portfolio returned gazillions last year. How about yours?" Even gazillions matter not if the S&P 500 returned gazillion plus one, because all the Club had to do was buy shares in an S&P 500 index fund and spend more time with their loved ones or watching sports on TV. Or both.

So, how does the Dinero Club's 10x/5y Rule Breaker performance compare with the most common benchmark of investment performance, the S&P 500? We'll choose a few returns for that index -- 6%, 8%,  11% -- based on various studies showing that the long-term average performance of stocks ranges from 8% to 11%. Given that we've had above-average performance for quite awhile, 6% reflects that we may face the below-average returns for some time.

         2001     2006   return CAGR 
RB Port $50,000 $108,500 117%   18.8%
S&P 500 $50,000 $ 66,911  34%    6.0%
S&P 500 $50,000 $ 73,466  47%    8.0%
S&P 500 $50,000 $ 84,252  69%   11.0%

(CAGR, or compound annual growth rate, reflects the fact that gaining 11% per year for five years on your investment does not result in a straight-line 11 x 5, or a 55% gain, but a 69% gain. It's the same principle used in the accounting Rule of 72, which says that to find how much time it will take for your investment to double at a given rate of return, divide 72 by that rate of return. If you earn 9% per year, it will double in eight years.)

The Club's results clearly beat long-term market averages, even though four of its five stocks take a whipping. And, what if every one of the investments takes the fast lane to the Great Investing Graveyard in the Sky, except old Organucopia, which blasts through with 10x/5y? In that event, the Club still earns 100% overall, a 14.87% annual return that beats the S&P 500. Very, very nice.

The math shows that 10x/5y is a good shorthand for examining possible Rule Breaker returns, given our assumptions that most of our risky investments will not succeed. Of course, you've already thought of many variations that affect the numbers here. For example, if we invest in more than five stocks or if we invest less than 20% in one, as we have with many Rule Breaker purchases, it dilutes the effect of a 10x/5y return on the portfolio's overall return. But, for now, the math shows that 10x/5y is a good rule of thumb for choosing among competing candidates.

A Celera winner and a joke
First, Tom Headricks provides a Community Perspective on Rule Breaker port holding Celera Genomics (NYSE: CRA). Tom's post is a thought-provoking must-read. Highly recommended. 

Second, How many surrealists does it take to change a light bulb?

Answer: Fish!

Have a great day, and Fool on!

Tom Jacobs (TMF Tom9) lives in Old Town, Alexandria, not far from Fool HQ, so he won't get lost on his way to work. That's why he seriously considered Miles on Video. At press time, he owned shares of Celera Genomics. To see his stock holdings, view his profile, and check out The Motley Fool's  disclosure policy.