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.
But McDonald's was still a great brand. For years, it had executed on its plan and become one of the most consistent and efficient restaurants around. And considering that all the players in the market were hurting, it seemed unlikely that the burger wars would last forever. And they didn't. Investors who bought at sub-$15 prices that spring had a double in about a year.
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 Disney
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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 does not have a position in any of the stocks mentioned in this article. Pfizer is an Inside Value recommendation. Disney is a Stock Advisor pick. The Motley Fool has adisclosure policy.