Talk about a roller coaster ride. 2007 presented investors with many surprises -- and quite a few expected problems -- ranging from subprime mortgage defaults to term auction facility to sticky inflation. Agriculture boomed, the Fed surprised, homebuilders collapsed and Google (GOOG) and Apple (AAPL) were unstoppable.

As we launch into 2008, now is a good time for us to look back and reflect upon what lessons 2007 provided us. For those who paid attention, there were many insights to be gained, even wisdom to be attained. Some of these we learned through observations; others, we learned the old-fashioned way (painfully).

What follows is a mix of fundamental, economic, technical and even philosophical lessons that those savvy CEOs, fund managers and individual investors who were paying attention picked up in 2007. My hope is that you will glean something worthwhile from the misfortune of others.

1. Ignore market rumors: Sometimes the big bucks don't even have to make the buy; they need only to be rumored to be kicking the tires. That was never truer than in 2007. It seemed every time some firm was in trouble, the same gossip was floated that Warren Buffett was about to buy it. Time and again, these tales proved to be unfounded money-losers.

This year's most egregious example was Buffett's imminent purchase of Bear Stearns ( BSC). I don't know who bought on the rumor that Mr. Derivatives-Are-Financial-WMDs was going to buy the poster child for bad CDO bets, but if they merely gave it even a millisecond of thought, they would have seen how obviously absurd it was.

That The New York Times' Dealbook got suckered into printing this just shows you how pernicious these rumors are. The stock was as high as $123 the day of the rumor. Yesterday's closing price was $88.

Anyone who bought homebuilders or Bear Stearns stock on the basis of either of these rumors -- or nearly any other stock that had similar rumors floated throughout the year -- lost boatloads of money.

2. Buy sector strength (and avoid sector weakness): It's a truism of real estate -- it's better to own a lousy house in a great neighborhood than a great house in a lousy one. And the same is true for stock sectors. Buying mediocre companies in great sectors generated positive results, while great companies in poor sectors struggled.

The losers are obvious: The homebuilders, financials, monoline insurers and retailers all struggled this year. The winners? Anything related to agriculture, solar energy, oil servicing, industrials, software, exporters, infrastructure plays -- even asset-gatherers thrived. Stocks in these groups consistently showed up in the 52-week-high list.

Goldman Sachs ( GS ) is a perfect example. Despite record revenue and earnings in 2007, the stock was up less than 15% in 2007. In 2006, on much weaker revenue and profits, shares climbed more than 50%. Great house, bad neighborhood.

3. Never blindly follow the "big money": Why? Because professionals make dumb mistakes, too. 2007 saw a number of surprise investments where so-called smart money bought big chunks of troubled companies -- Bank of America ( BAC) buying a chunk of Countrywide ( CFC) being Exhibit A. Many people chased the so-called smart money into these trades. Unfortunately, all of these trades have proven to be jumbo losers. If this keeps up, the "smart money" may need to start looking for a new nickname.

4. Day-to-day stock action is mostly noise: This is blasphemy to some people, but it's true. Markets eventually get pricing right, but the key to understanding this is the word "eventually." Over the shorter term, markets frequently under- or overprice a stock before settling into the right approximation of value. This process typically occurs over broad lengths of time. Unfortunately, that doesn't stop some rather suspect interpretations of what these short-term movements mean. I look at these tea readings as Rorschach tests, revealing more about the speaker than they do about the subject.

Case in point: the homebuilders. It seemed that every time there was even the slightest uptick in the group, some bozo would declare that the bottom of the real estate cycle was in. Indeed, every dead-cat bounce or short squeeze was trotted out as proof positive that the housing problem was over. Only it wasn't, and the homebuilders cratered some 70% off their highs. You don't need to be a technician to know this: The little squiggles on the chart mean a whole lot less than the big squiggles do.

5. P/E matters less than you think: One of the things I heard a lot this year was "I (dis)like this stock because it has a (high)low P/E." News flash: P/E ratios alone tell you very little about a stock's future prospects.

If that sounds like blasphemy, please look at a few examples: Google, Apple and Mosaic ( MOS) all sported high P/Es at the beginning of the year. Their stocks have done splendidly. On the other hand, back in January, retailers, financials and homebuilders all had reasonably cheap P/Es. (How'd they do?)

It helps if you think of P/Es not as a photo but as video. The direction matters more than the mere number: Were P/Es likely to come down as sales ramped up? Or were P/Es modest because they were at the top of a profit cycle, and were likely to fall? The answer to these questions explains the difference between the winners and losers.

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) and Merrill Lynch ( MER), big banks like Citigroup ( C) and Washington Mutual ( WM), and GSEs like Fannie Mae ( FNM) and Freddie Mac ( FRE) 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) is an online broker; what was it doing writing subprime mortgages?

Why was Bear Stearns running two hedge funds?

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

And exactly what was GM's ( GM) 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 badly), they wouldn't be in as much trouble today.

11. Fess up: Whenever a company runs into trouble, it seems to take a page from the same PR playbook. First, it says nothing. Second, it denies. Finally, it makes a begrudging, pitifully small admission. Eventually, the full truth falls out, and the stock tanks with it.

Companies (and their shareholders) are much better served when the company admits its mistakes, apologizes and tries to make amends. Promising to do better in the future never hurts either. Even when bad news hits a stock, a quick admission of error makes the pain less severe than it might have otherwise been.

These companies practiced this philosophy and spared their shareholders billions in losses:
  • After a disastrous screw-up on New York's JFK tarmac, JetBlue's (JBLU) CEO issued a very sincere mea culpa via YouTube. The company not only took responsibility for the problem, it outlined the changes it was making to avoid it in the future. JBLU shares suffered as oil raced toward $100, but it could have been much worse had the company not addressed the problem so directly.
  • Mattel (MAT) responded aggressively to the discovery of lead paint in children's toys manufactured in China. It proactively worked with the Consumer Product Safety Commission, took out full-page newspaper ads, set up 800 numbers and issued vouchers for replacement toys.
  • After Apple dropped its price 33% on its new iPhone, recent purchasers of the $599 version yelped loudly. Apple offered a $100 Apple store gift certificate to ease the sting. Everyone was more or less happy.
While these examples are all in the consumer space, the lessons apply to other firms. The truth comes out eventually.

12. Never forget risk management: This applies to everyone who is involved in anything financial: investors, companies, even the Fed.

Consider what could possibly go wrong, and have a plan in place in the event that unlikely possibility comes to pass. If there is to be upside, then there must also be a corresponding and proportional downside.

For investors, that may be something as simple as using stop losses and being appropriately diversified.

For others, it means knowing what risk factors face their businesses: the price of oil, interest rates, a hurricane. You may not be able to control these things, but you can anticipate, prepare for, even hedge against all of them.

13. The trend is your friend: Despite the year's parade of horribles, this market cliché was proven true once again. The Dow, S&P 500 and Nasdaq are all higher this year, as their long-term trends have been tested but remain intact.

The exception, the Russell 2000, broke its trend earlier this year. That made trend traders abandon the small-cap index, which has since fallen even further. This confirms the corollary: "except for the bend at the end." As long as the index trend lines stay intact, investors can sleep easy. But once those trend lines break, well, then you better apply some of the earlier lessons (see numbers 2, 3, 4, 6, 7 and 12!).

At the time of publication, Ritholtz 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.

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