Lessons From 2007: A Baker's Dozen

6) Ignore deteriorating fundamentals at your peril: At various points in 2007, we saw or read recommendations to buy the unholy trinity: retailers, financials and homebuilders. Each of these buy recommendations came despite the deteriorating economic fundamentals of each sector. That turned out to be a recipe for big losses.

One would think this doesn't need to be said, and yet it does: When the fundamentals of a given market, sector or consumer group are decaying, profit gains are sure to slow.

7) Nothing is more costly than chasing yield: For fixed-income investors, what matters most is not the return on your money, it's the return of your money. I learned this early in my career, and never was it more true than in 2007. Reaching down the risk curve for a few bips of additional yield is one of the dumbest things an investor can ever do.

8) Know what you own: This very basic issue was mostly forgotten in recent years, and it was forgotten by pros and individuals.

The investment banks like Bear Stearns, Morgan Stanley (MS - commentary - Cramer's Take) and Merrill Lynch (MER - commentary - Cramer's Take), big banks like Citigroup (C - commentary - Cramer's Take) and Washington Mutual (WM - commentary - Cramer's Take), and GSEs like Fannie Mae (FNM - commentary - Cramer's Take) and Freddie Mac (FRE - commentary - Cramer's Take) were scooping up assets apparently without doing their homework. The complexity of these pools of mortgages almost guarantees that no one truly knows what's in them (see the next rule). If you don't know what you own, how can you properly manage risk?

9) Simple is better than complex: Here's why this blindingly obvious observation bears repeating:

Start with a few million mortgages of varying credit-worthiness and create a series of residential mortgage-backed securities (RMBS) from them. Then take the RMBS and stratify them. Then leverage them up into collateral debt obligations (CDOs). Once that bundling is complete, make complex bets on which layers might default, via credit default swaps (CDS). Gee, how could anything possibly go wrong with that?!

It turns out plenty can go wrong there. Remember, in the universe of financial engineering, simpler is better than complex.

10) Stick to your core competency:

E*Trade (ETFC - commentary - Cramer's Take) is an online broker; what was it doing writing subprime mortgages?

Why was Bear Stearns running two hedge funds?

Isn't H&R Block a tax preparer? It was making mortgage loans why?

And exactly what was GM's expertise in underwriting mortgages? (The snarkier among you might be wondering exactly what business GM's expertise is in.)

Had these companies stuck to what they did best (or least bad), they wouldn't be in as much trouble today.

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At the time of publication, Ritholtz had no positions in stocks mentioned, although holdings can change at any time. Barry Ritholtz is the chief market strategist for Ritholtz Research, an independent institutional research firm, specializing in the analysis of macroeconomic trends and the capital markets. The firm's variant perspectives are applied to the fixed income, equity and commodity markets, both domestically and internationally. Other areas of research coverage also include consumer, real estate, geopolitics, technology and digital media. Ritholtz is also president of Ritholtz Capital Partners (RCP), a New York based hedge fund. RCP is driven by the analysis performed by Ritholtz Research. Ritholtz appreciates your feedback; click here to send him an email.