THE BLOG
08/29/2007 12:25 pm ET Updated May 25, 2011

Naked Swimming Lessons

"You don't know who's swimming naked 'til the tide goes out," says Warren Buffett. Well, now we know.

The subprime tide has carried the ocean back to its ancestral home. Up and down the coast are the beached naked corpses of the real estate bust, looking downright unpleasant without their clothes. There are: the drowned shaky lenders, like New Century, who lent money to those who could never repay it; the once lean and mean hedge funds, whose risk modeling gave as much cover as Britney's skirts; and the whales, like Countrywide who now look silly in a bikini, having protested all along they had on a wet suit up to their ears.

There won't be any lessons learned from this debacle because regulators always fight the last war -- and investors do, too. Instead of looking out for the next bubble and avoiding the inevitable denial that will surround it, these players will end up retching at the phrase "real estate" without ever understanding the enemy was not an asset class, but themselves. I saw the same psychological phenomenon after the Internet collapse when investors renounced all stocks, never learning that the problem was speculating in the wrong ones. These same people went headlong into real estate taking out adjustable rate mortgages on overvalued property, never realizing that in a game of musical chairs, the music always stops.

If I were trying to give a one-word lesson for swimming naked, it would be the following: don't. Don't leverage your investments without understanding the worst case scenario (the real one, not the one modeled by your "risk manager" or your mortgage broker); don't invest in bad speculative derivative pieces of nonsense like CDO's, CLO's or any other acronym that sounds like a government agency; and try to use common sense to avoid your neighbor's fate, since we all know how uncommon such sense is.

If you must do something just because your neighbor did it (or because you saw an ad promoting it), then try to get a second opinion. If you run a hedge fund, give up modeling your risk based on flawed superficial bits like beta and start actually understanding what you own. And if you can't do any of the above, then just move to an ashram and give away your worldly possessions -- since you'll end up doing it anyway, just without the inner peace.

If the tone of this entry sounds vindictive and self-righteous, that's because it is. This is the main recourse left to us stodgy, conservative investors after we suffer through the excesses when the swashbuckling speculators made us look stupid. I suppose having oodles of cash on hand when everyone else is filing for bankruptcy is good reward too. But there's nothing like the cheap indulgence of saying "I told you so."

Then again, there's nothing more intrinsically depressing than seeing human nature fail and fail. Even when the failure creates large investment opportunities for scavengers like me, I am often asking why, even as I understand the excesses of fear and greed that created this whole mess.

The most interesting question is where the next bubble will form. Since I started managing money in 1996, it has hit small stocks, then big stocks, then tech and then small stocks again and then real estate. The ever-growing money supply has spawned numerous bubbles and the Fed's easy money policy has made sure that another always replaced the one that had just burst. It's possible that in cutting the discount rate instead of the Fed Funds target, the central bank was finally saying: Enough, we will no longer enable your addictions. If so, we may not have a bubble for awhile as the tide runs out even further. The question you should now ask yourself is: will I feel embarrassed, ruined or just plain naked if high tide doesn't return soon? If so, grab a towel -- quickly.