The Low-Risk Wealth Solution

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Here's a new definition for you:

Academics (n): those who are (painfully) adept at creating theories that are scientifically supported, sensible, creative, and completely useless in the real world.

To illustrate my point, let's look at the academic perspective on the correlation between risk and return in the stock market. The egghead's point of view is the higher the risk, the greater the return. But that doesn't translate logically to an investor. I mean, "To outperform the market, buy the riskiest stocks!" does not a motto make.

So, how do these bookworms arrive at this conclusion? They use back-testing, which means they take all the stocks in the universe, divide them into groups based on risk, and see which group did the best.

Now, call me a Fool, but that sounds like the way a computer -- not a person -- would manage a portfolio. Why arbitrarily buy a fifth of the stocks in the entire market when you can cherry-pick the best? (There's no need to answer that. I was simply proving my point.)

A simple principle
With individual stocks, low risk can equal high return. This is because each stock has an intrinsic value. The more a stock descends below its fair value, the less likely it is to fall farther. And the upside will be far greater when it bounces back to what it's actually worth.

Take, for instance, SanDisk (Nasdaq: SNDK). During the tech stock deep depression after the popping of the Internet bubble, SanDisk was taken out and shot. Everyone was worried about flash memory becoming a commodity and that the future held nothing but one price war after another.

But the company was still the leader in flash and had an attractive stream of royalty revenues. Nothing was certain, but it seemed like an intriguing investment. And investors who took the plunge made piles as the stock rocketed from single-digit lows to above $60.

The truly great investors are able to take advantage of short-term market irrationality. They see the reward, even in times of risk. I'm thinking of Buffett and Munger with Anheuser-Busch (NYSE: BUD) and Lexmark International (NYSE: LXK); Bill Miller with Sony (NYSE: SNE) and Sprint Nextel (NYSE: S); and Marty Whitman with Forest City Enterprises (NYSE: FCE-A) and Brookfield Asset Management (NYSE: BAM). In the case of each company, the managers were able to purchase stocks when temporary bad news or market sentiment drove down prices, and they thereby achieved excellent returns.

If you're looking for the sweet spot -- where you get lower risk and higher returns -- look for stocks trading at a discount to their fair value. Motley FoolInside Value can help you find them. Simply click here to learn more.

This article was originally published on Jan. 17, 2006. It has been updated.

Fool contributor Richard Gibbons, a member of the Inside Value team, considers it risky to go anywhere without an umbrella. He does not have a position in any of the stocks mentioned in this article. Anheuser-Busch is an Inside Value recommendation. The Motley Fool has adisclosure policy.