Over the years, we’ve heard of dozens of different investment theories and systems.

From what we can tell, almost all of them work – sometimes.

When you are investing in a market in which stock prices have gone up 17 times (judged by the Dow) over the last 32 years, almost any approach should have positive results.

The real test of an investment system is during a bear market. Then almost nothing works!

But our purpose today is to introduce you to the world of investing… as we understand it.

Which is worth a warning…

Many people are far better investors. We are interested in investing only because we have to be. And we try to understand it in its simplest terms… because we don’t want to spend much time on the practical details.

Still, we’ve thought a lot about the theory behind it…

Throwing Darts

That was why the Efficient Market Hypothesis was so attractive to us.

In the 1960s, finance academics started using computers to crunch large amounts of stock market data.

They noticed that markets were remarkably “efficient” at reflecting publicly available information about companies in stock market prices.

As a result, they thought there was no point in trying to beat the market using publicly available information. By the time that information made its way to you, it was already reflected in the price.

You were as likely to make money by throwing darts at a page of the Wall Street Journal as by doing painstaking analysis.

We were happy to believe it; we like to throw darts.

But then we discovered the truth: Hard work and discipline pay off when you are investing, just as they do almost everywhere else.

But one of the perversities of investing is that a little bit of work is probably worse than none at all. Throwing darts at a page of the Wall Street Journal will still probably beat your average stock picker.

How could that be?

A Fat Seal in a Sea of Sharks

When you pay a little attention you become caught up in the fads and fashions of the investment world. The next thing you know you are wearing the same thing other investors are wearing… and voicing the same opinions.

That is when you will get the worst returns possible. You will buy high and sell low. You will be at the bottom of Wall Street’s food chain – a fat seal in a sea of sharks.

The evidence shows it is hard for the typical investor to survive, let alone make money. The averages mask the risk and the damage.

This is because the market indexes take out the losers. Since 1980, 320 companies have been taken out of the “market-cap weighted” S&P 500 (SPY). (The index has room only for the 500 largest companies as measured by the total value of their outstanding shares.)

Two-thirds of all the stocks in the Russell 3000 Index (IWV) – which represents about 98% of the US stock market – have underperformed the index.

And since 1980, 4 out of 10 Russell 3000 stocks have suffered a permanent impairment of 70% or more from their peak value.

Even the pros find it hard to “beat the market.” So far in 2014, the S&P 500 is up 12%. The average hedge fund is flat for the year.

Over the last six years, the S&P rose 160%. And the super-clever hedge funds?

Up 41%.

Stocks for the Long Run

What’s an investor to do?

First, the evidence strongly suggests that stocks beat bonds over the long term.

Over the past 100 years, investors in stocks have earned an average annual return of about 7%. Nothing else – cash, gold, real estate or bonds – came close.

Of course, past performance is no indication of future performance.

Most of the gains of the last 100 years came during the last three decades. And they were disfigured by a colossal credit inflation that we are unlikely to see again.

So, let’s begin by going back to what we’ve learned so far. Most of your gains will come from asset allocation, not stock selection.

In other words, what’s most important is being in the right place at the right time.

For example, a recent study by François Trahan of research group Cornerstone Macro concluded that about 70% of the movement in financial markets is the result of macroeconomic trends.

The first question then is which market to be in.

On the evidence of the last 100 years, we don’t have much of an alternative: The best market to be in is the equity market.

Let us now ask which equity market is the best one.

Until recently, there wasn’t much of a choice. You had only to decide which industry sectors to be in. You didn’t have an opportunity to invest in foreign markets. Now it’s easy. You just buy an exchange-traded fund or a mutual fund.

But how do you select the market to be in?

Value, value, more value… always value.

Of all the theories we’ve come across, the one that makes the most sense – and the one with the most supporting evidence – is “value investing.”

Mr. Buffet’s Simple Formula

Not coincidentally, it’s the approach preached by a certain well-known investor from Omaha.

Warren Buffett is an eloquent and influential proponent of value investing. But it is his wealth that is most persuasive. Using this investment system he has become, off and on, the richest man on Earth. (He is now fourth on the list, with a net worth of a mere $58 billion.)

The idea is simple: A stock represents an ownership interest in a company. Its role in life is to render to its owners a share of the company’s earnings.

To know what the share is worth, you calculate how much in earnings it will bring you. Then you discount this stream of earnings to “present value.”

The idea is that $5,000 now is worth more than $5,000 five years from now. This makes sense. After all, if you had the money now, you could invest it and earn interest on it over that time.

Still, you are not quite finished. You also want a “margin of safety.” You should insist on paying less than you think the stock is really worth to protect yourself from error. (The bigger the margin the better.)

Once you have established what the stock is worth, you compare it to the market price. If the market price is higher, you stay away (or sell, if you own the shares already). If it is lower, you consider buying.

Voilà! That’s all there is to it.

If you do your research carefully… and are disciplined and patient… you will not necessarily make more money than other investors. But you’ll deserve to make more money, which is all we mortals can ever do.

CAPE Crusader

Value investing applies to individual stocks. But you can use the same principle to help with asset allocation decisions too.

This happens naturally. As the stock market rises in price, the value investor gradually sells his shares. He is squeezed out of expensive markets – as Buffett was in 1968.

That’s when it’s time to turn your gaze elsewhere. Now you can choose a market where prices are not so high.

Much research has been done on the subject. Maybe the best known is by Yale economics professor Robert Shiller.

Shiller popularized a concept first introduced by value investors Benjamin Graham and David Dodd in their 1934 book, Security Analysis: a price-to-earnings ratio based on average earnings over more than one year.

Graham and Dodd noted that looking at just one year of earnings didn’t give you much of an idea of a company’s earnings power. Earnings are unpredictable over short periods. Only time tells whether a company has real earnings power.

Shiller’s creation, the cyclically adjusted price-to-earnings (or CAPE) ratio, takes an average of 10 years of earnings and adjusts them for inflation. Then it looks at this average versus a company’s market price.

Buy Low… Sell High

This works for entire markets too.

Shiller’s model can tell you whether an entire stock market is expensive or cheap relative to its history.

Back testing his idea, Shiller found what you would expect: The more expensive a market became, the lower would be the expected capital gains over the following 10 years.

Specifically, he found that US stock prices hit extremely high CAPE ratios in 1901, 1928, 1966 and 1996. Each time, investors at these peaks had losses 10 to 20 years later.

You can apply the same analysis to foreign markets too.

One study looked at 14 foreign markets. When they traded on CAPE ratios of 32 or higher, returns averaged about zero over the next 15 years.

The inverse is also true. Below average CAPE ratios led to above average returns.

This makes asset allocation easy: You favor markets with low CAPE ratios.

Right now, the S&P 500 trades on a CAPE ratio of over 27.

That’s roughly where it was at the previous stock market peak in 2007. The only other two times the S&P 500 was this expensive was during the dot-com bubble and right before the 1929 crash.

Three of the cheapest country stock markets in the world are Greece (on a CAPE of 2.8)… Russia (on a CAPE of 5.2)… and Portugal (on a CAPE of 6.8).

If you want to buy low and sell high, these are good long-term bets.

Of course, most investors will look the other way.