4. Unlikely is not impossible.

Bear Stearns made this common error in more than one way. First, it certainly was not impossible that a severe liquidity crisis would develop. Second, their big bet on subprime mortgages depended on housing prices not falling to any significant degree. This had occurred in the 1980s when energy prices collapsed and home prices fell in the oil belt. Just as is occurring today, homeowners were mailing in their keys to their mortgagor. In addition, today's subprime mortgages had much more lenient terms (less equity required) than was the case in prior periods - making them more risky. And, while we had not experienced a nationwide fall in home prices of any degree since the Great Depression, that did not mean that we could not experience one. In fact, one of the more common errors investors make is to fail to understand that just because something has never happened does not mean it cannot happen (consider the events of September 2001). Thus, one of the most important principles of prudent investing is to never treat the unlikely as impossible and to also not treat the likely as if it is certain.

5. In a crisis, the correlation of equity asset classes tends to rise.

Broad global diversification across many equity asset classes, including those with low correlation to other portfolio assets, is one of the principles of prudent investing. However, investors also must understand that, in times of financial crisis, correlations among equity asset classes (and all risky assets such as junk bonds) tend to rise. Evidence of this is how quickly the subprime crisis spread around the globe, impacting all equity asset classes (and all risky bond classes as well). Even with a significant tailwind of rising currency values, international equities fell. In this crisis, the only safe harbor (besides commodities) was the highest-quality fixed-income instruments. That is why it is important that the portfolio have sufficient high-quality fixed-income assets to ensure that overall portfolio risk is at the appropriate level.

6. Active management won't protect you.

Whenever there is a situation like an Enron or a Bear Stearns, you will hear about the need for active management to protect you from such "obvious" situations. Nothing could be further from the truth. First, index funds simply own the market cap weighting of all stocks within the index. That means that in aggregate, active investors also own the same proportional share of any given stock. A good example of the failure of active management to protect you is that Bear Stearns was one of the largest holdings of the Legg Mason Value Trust that is managed by legendary investor Bill Miller. Miller had beaten the market 15 years in a row. However, that streak was broken in 2006 when Miller underperformed the S&P by about 10 percent. His 2007 performance was even worse. And in just the first three months of 2008, his fund is underperforming the S&P 500 by a wide margin once again - with Bear Stearns contributing to the underperformance.

7. Hedge funds won't protect you either.

Some of the largest losses were experienced by hedge funds, including two run by Bear Stearns. One of the problems with hedge funds is that their risks often highly correlate with the risks of equities at the worst of times, during crisis. So just when you need the low correlation that they advertise as a benefit, the correlations rise. That is just one of the many reasons you should avoid investing in hedge funds. What hedge funds are effective at is transferring assets from the country club set to investment bankers.

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