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
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
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
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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. 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.