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 this: 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 the bookworms arrive at this conclusion? They use back-testing, which means they take all of 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 further. And the upside will be far greater when it bounces back to what it's actually worth.

Take, for instance, First Marblehead (NYSE:FMD), which provides outsourcing services for the rapidly growing market for private-education lenders. First Marblehead does all of the work -- designing the programs, evaluating the creditworthiness of borrowers, and handling collections. In return, it gets upfront fees and a portion of the future profits after it bundles up student loans and sells them as securities.

I first liked First Marblehead in the mid-$30s and bought shares a few weeks after I wrote about it last summer. But the market was fearful that JPMorgan Chase (NYSE:JPM) or Bank of America (NYSE:BAC), two customers that accounted for more than half of First Marblehead's revenues, could decide to take their business in-house. Plus, there were concerns about the quality of the residual earnings and the general sustainability of the business model. First Marblehead's CEO resigned when the news broke that he had bought $32,000 worth of gifts for a Bank of America student-loan executive.

The company was beaten down to the low $20s, and I bought all the way down to $22. It seemed to me that the market was too panicked about all the potential bad news -- which was mostly unsupported speculation -- and not paying much attention to the reality that First Marblehead has some decent competitive advantages and was still showing excellent growth. The subsequent bounce-back to $48 has been fun.

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 American Standard (NYSE:ASD), Bill Miller with Centex (NYSE:CTX), and Marty Whitman with POSCO (NYSE:PKX). In the case of each company, the managers have purchased shares when temporary bad news or market sentiment drove down prices, recognizing that buying at such cheap prices generally results in excellent long-term 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 owns shares of First Marblehead but does not have a position in any of the other stocks mentioned in this article. JPMorgan Chase, POSCO, and Bank of America are Income Investor selections. First Marblehead is a Motley Fool Hidden Gems recommendation. The Motley Fool has adisclosure policy.