Nobody's better than academics at creating theories that are scientifically supported, sensible, creative, and completely useless when it comes to the real world.
Take the academic perspective on the correlation between risk and stock market returns. To an egghead, the higher the risk, the greater the returns. To outperform the market, buy the riskiest stocks.
How do these guys arrive at this conclusion? Using backtesting. 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 to me 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? And with individual stocks, low risk can equal high return.
A simple principle
This is true 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 greater the upside when it bounces back to what it's actually worth.
Yahoo! isn't the only example. Most great investors use this technique to achieve their extraordinary returns. I'm thinking here of Warren Buffett with Wells Fargo
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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. Tyco is an Inside Value recommendation. UnitedHealth Group is a Stock Advisor recommendation. He does not have a position in any of the companies discussed in this article. The Motley Fool has adisclosure policy.