7 Lessons From the Meltdown

Editor's note: This story has been updated.

If ever something could be considered a teachable event, it's the current financial tsunami. When it's finally over -- and let's hope the end comes sooner rather than later -- it will provide enough lessons to fill up a doctoral seminar. But you don't have to spend $50,000 for a year at some elite university to acquire those pearls of wisdom. We'll give you seven for the cost of this magazine. These lessons won't restore your wealth. But someday, and maybe even before the financial markets recover, the knowledge will prove valuable.

1. Where's the money? You'd better know -- literally.

The reported $50-billion swindle orchestrated by Bernard Madoff, the $8-billion fraud allegedly perpetrated by Texas billionaire R. Allen Stanford and other fleece jobs should put to rest the notion that you can get rich from unpublicized investment opportunities unavailable to mere mortals. These secret deals frequently turn out to be Ponzi schemes or other scams.

If you give any adviser discretion to buy and sell investments without your prior go-ahead, you must demand to know where your money sleeps. As a client, you should get a monthly statement listing all positions. Many advisers extol private real estate deals or energy partnerships. Ask for property descriptions: locations, addresses, photos. If you're an investor in a bundle of mortgages or business loans, do you know who the borrowers are? Investors in something called Agape World thought they had a piece of a package of well-screened business loans that paid as much as 16% with nary a default. The loans and the interest payments proved to be fake, and the investors lost more than $370 million total.

2. New investment gadgets won't save you.

Consider "long-short" mutual funds. As we noted in the March issue (Hedges That Didn't Get Hosed), these funds flopped last year in their mission of protecting shareholders in any kind of market. The idea seems sensible. By owning both long positions (that is, owning stocks the old-fashioned way) and short positions (which profit when the stock price falls), you play both ends against the other. But in practice, a fund that holds more longs than shorts -- which is generally the case in this category -- still loses badly in a harsh bear market. The funds' creators over­promised and underdelivered.

There's a good chance that other gadgets, such as principal-protected notes (see Savings Guarantees You Can Trust, April), will also disappoint because any complex trading model is vulnerable to unusual events, such as the failure of big banks or a two-year recession. A bunch of all-purpose bond funds that were built around derivatives-trading strategies have already blown up. if you’re unwilling to take as many risks with the money you’ve made back in stocks, pair a fund that tracks Standard & Poor's 500-stock index with short-term government or municipal bonds.

3. Don't deify those who warned about losses.

Few people who get paid to predict the market's fluctuations get it right. But that doesn't make heroes out of those who are beating their breasts about how they prophesied the disaster. Spouting generalities such as "irrational exuberance" falls short of predicting crushing losses. It's especially important to keep this in mind as you examine the scintillating '08 results of such bearishly inclined funds as Federated Prudent Bear (symbol BEARX) and Comstock Capital Value (DRCVX). Those gains are no more sustainable than any irrational real estate or commodities boom. They aren't sources of market wisdom, but actors you cast to play a specific part during a disaster.

However, if you have an adviser who isn't habitually negative but urged you to switch more into cash and Treasuries a year ago, then you should shower him or her with praise. Sending over a nice bottle of wine or a bouquet of flowers would be an appropriate thank-you gesture.