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. From the egghead's point of view, the higher the risk, the greater the return. But that doesn't translate logically to ordinary investors. "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 farther. And the upside will be far greater when it bounces back to what it's actually worth.
Take, for instance, Sunrise Senior Living (NYSE:SRZ), the largest senior-living services company around. The Balanced Budget Act of 1997 caused strain on the senior-living industry by cutting payments that providers received from Medicare. While Sunrise had few Medicare patients, the entire industry was suffering from overbuilding, labor shortages, and litigation. To add to these woes, Sunrise made a poor acquisition, which sent its share price to a split-adjusted $5 in 1999.
But the company was still the strongest assisted-living operator around, and all these negatives were short-term issues. The company was trading at a significant discount to its fair value. Investors who recognized that the market had gone way too far have achieved great profits -- the shares are trading for more than $31 today.
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 Warren Buffett with H&R Block (NYSE:HRB) and American Express (NYSE:AXP); Bill Miller with U.S. Steel (NYSE:X) and eBay; and Marty Whitman with MBIA (NYSE:MBI) and White Mountains Insurance (NYSE:WTM). 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 FoolInsideValue 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 H&R Block, but none of the other stocks mentioned in this article. eBay is a Stock Advisor recommendation. The Motley Fool has adisclosure policy.
