Follow the smart money. For years it has been a cliché of Wall Street. Savvy institutional investors were a sure guide to the next new idea, and so retail investors should follow their lead. It was the natural pecking order of markets: The less sophisticated should learn from the smart; Main Street should follow Wall Street. But as recent events have shown, that was a flawed idea.

Today, what passed for sophisticated global finance lies in ruins. The top U.S. investment banks are gone—acquired, bankrupt, or starting anew as commercial banks. And a rapid consolidation is underway in the commercial banking sector, as the strong swallow the weak at the behest of the government.

There are lessons to be learned from this series of events, not least of which is how smart money got it so wrong, and how the supposedly "dumb" retail investor got it fundamentally right.

Let's begin with the troubles in global finance. The failings of modern Wall Street can be summed up in three ideas: leverage, credit risk, and low-probability risks. To start, if there was one lesson ever to be learned about financial risk from the Great Depression, it was this: Leverage in combination with volatile assets is a poisonous brew.

Today, mortgage securities are referred to as "toxic assets." But they are only toxic to the extent that financial intermediaries bought them not with cash but with too much borrowed money, and so were undercapitalized when market values went south.

Consider the proprietary trading desk of a modern investment bank—circa early 2007—but this time as if the bank were a retail investor. Imagine a private client arriving with $500,000 in lifetime savings to invest. The investor proposes to borrow $15 million dollars, a ratio of 30:1, based solely on an equity investment of $500,000 and his or her investment prowess. The total $15.5 million is invested in various asset markets. Simple math demonstrates that a small fluctuation in market values, say a 10% drop, would lead to a loss of $1.5 million, three times the investor's initial capital, and bankruptcy. An imprudent approach to risk management to say the least.

But during the 1990s, modern investment banks prospered on such thin capital structures relying on two critical assumptions. The first was that the spread between what they were investing in and the cost of borrowed money was very large and, consequently, able to generate huge profits. The temptation to take ever-greater risks rose in the past five years, with interest rates at low levels not seen since the 1960s. The second was that the assets they held were imperfectly correlated. So, there would be no simultaneous large price shock to all of their holdings.

However, when certain assets linked to real estate began to deteriorate, the cost of money began to rise and correlations among assets increased; the great houses of finance came down.

The second failing was inattention to credit risk. As diversified portfolios have proliferated in modern financial systems there has been a tendency to downplay credit risk. Individual borrowers may default, which would vary with economic conditions. But a diversified portfolio would largely protect against such risk and the impact of credit quality on returns would be modest.

The fastidious banker, carefully assessing creditworthiness, was replaced by a fragmented process. No one-from the originator to the securitizer to the ultimate investor in mortgage securities—took responsibility for individual borrowers' credit quality or aggregate credit risk.

None of the agents in that process had previously asked a simple question: When mortgage rates rise, what happens? It is perhaps the most striking failing of the smart money-the failure to run a simple "what if" spreadsheet on credit quality.

Combine leverage and inattention to credit quality with the third failing, the failure to anticipate low-probability risks, and the story is complete. One of the great contributions of modern finance is a statistical understanding of the world, permitting new investment techniques like quantitative investing and better risk management tools. One of the great failings of the smart money was to focus unduly on the central tendency, and ignore the low-chance events. There may well be a 98% probability that your capital position is secure, but once in a great while—say, in 1929 or 2008—a 2% event comes along.

It's surprising that the best global financial institutions could overlook the fundamentals. Of course, it's not entirely fair to blame only savvy investors. Several million Americans took on debt they couldn't afford, and are mired in mortgage contracts they can't pay. Yet I tend to be more forgiving of these individuals, if only because the smart money knew that the buyers of exotic mortgages were undercapitalized households with little or no savings, bad credit records, and weak employment histories.