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:

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 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.

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.