While the dust has not yet settled on the Bear Stearns situation, the crisis provides us with an opportunity to review some of the principles of prudent investing. These principles have stood the test of time. And in the case of the latest crisis, they protected investors who followed them from experiencing catastrophic losses.

1. Liquidity is king.

There is an old adage on Wall Street that "liquidity can be an illusion - it is there when you don't need it and can disappear when you do." While Lehman Brothers apparently learned that lesson in 1998 (and did not make the same mistakes this time around), Bear Stearns did not. They did not line up sufficient liquidity to withstand a crisis - a run on their liquidity. Two issues exacerbated the problem. The first was that the securities that Bear Stearns had its capital tied up in were risky assets. In a liquidity crisis, the markets for such assets can literally disappear (there is virtually no bid). Had most of their assets been of greater credit quality, the problem would not have been as severe. The second problem was that the firm was highly leveraged, much more so than the other major investment banks. And when you are highly leveraged you have to be right all the time (because while you might be right in the long run, in the short run you can die, as Long Term Capital Management found out). This is one of the many reasons that we do not recommend hedge funds (many of them employ large amounts of leverage). And given the amount of leverage employed by Bear Stearns, they might have been considered not much more than a big hedge fund that happened to provide other financial services. One lesson for investors is that they should always have a sufficient amount of "emergency" reserves (a typical recommendation is to hold at least six months' spending requirements) in the form of short-term instruments of the highest credit quality so that they do not have to sell risky assets during a period of financial stress. And finally, if you know you will definitely need cash to meet a known obligation, that amount of funds should be invested only in instruments that have guaranteed liquidity (e.g., Treasury instruments).

2. High-yielding assets are risky, and it is likely that eventually the risks will show up.

We just don't know when it will happen, what might be the trigger, how deep the crisis will be or how long it will last. Those are all unknowable. Thus, the main role of fixed-income assets in portfolios should be to reduce the overall level of risk of the portfolio to an acceptable level, allowing the investor to hold the amount of equities that is appropriate given their own unique ability, willingness and need to take risk. Therefore, fixed-income instruments should be limited to only those of the highest investment grade. Those investors that followed that principle have basically avoided the problems of not only the subprime mortgage market, but also the junk bond market and the municipal bond market as well. Another important lesson is that equity investors could have diversified away much of the risks of investing in the equity of Bear Stearns, but investors in risky fixed-income assets suffered no matter how many different securities they owned because of the liquidity crisis.

3. Credit enhancement is nice, but not sufficient.

Because the main role of fixed-income assets in a portfolio is to reduce overall portfolio risk to an acceptable level, it is important to maintain the highest credit standards. That is why one of the principles of prudent investing for municipal bond buyers is to look through the credit rating of an insured bond and make sure that on a stand-alone basis the credit risk is acceptable. It is important to understand that municipal bonds are far less likely to default than a similarly-rated corporate bond. In fact, a single A-rated municipal bond is about 90 percent less likely to default than a single-A-rated corporate bond. Similarly an AAA-rated municipal is less likely to default than an AAA-rated corporate. Thus, a municipal bond that is AAA-rated because its credit has been enhanced by a corporate guarantee is not as safe as an AAA-rated municipal bond that does not require the guarantee of an insurer. The market knows that. Yields on insured bonds are higher than on similarly rated uninsured bonds. Investors should set high standards for the underlying ratings and not try to chase a few extra basis points in yield by purchasing bonds that rely on the credit enhancement to get a rating that passes the credit standard set by the investor in their investment policy statement.

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