Investing in the stock market is often compared to gambling. This analogy became particularly popular in the wake of the 1973 publication of Burton Malkiel’s A Random Walk Down Wall Street, which argued that the movement of asset prices is just, well, too random to outperform on a consistent basis. Most of the time, an active investor employing the tools of technical or fundamental analysis, the hypothesis goes, will underperform a passive investment strategy.
And this is exactly what is observed in the real world: Most money managers underperform the market in the long run. According to an analysis by NerdWallet, actively managed funds underperformed the market by an average of 0.56 percent (median of 1.36 percent) in the 10-year period ended December 2012. Even more to the point, a December 2013 study released by the National Bureau of Economic Research found that the average Sharpe ratio for all mutual funds that have been in existence for 30 or more years is 0.37, which compares unfavorably to the S&P 500 at 0.39.
The Sharpe ratio measures the risk-adjusted performance of an investment and can be used as a way to gain insight into where the returns are coming from in a portfolio. Two portfolios with with the same returns could have very different Sharpe ratios if one made risky bets and got lucky, and the other made safe bets that produced superior returns. A high Sharpe ratio is arguably the Holy Grail of investing: low risk, high reward. Or, at least, high reward relative to risk.
With the random walk theory in mind, it may seem like investments with high Sharpe ratios are rare. This is true to a degree, but these investments do exist, and a few enterprising money managers have developed strategies to capitalize on them. Take, for example, Warren Buffett. According to the NBE study, Buffett achieved a Sharpe ratio of 0.76 for the same 30-year period, during which the average mutual fund manager underperformed the market.
So somewhere out there in the world of equities there are Holy Grail investments. It flies in the face of conventional wisdom like the mantra of the high-return tradeoff (high risk, high reward), but the data don’t lie. Here are a couple of stocks that could fit into such a strategy.