In mid-July, a potential investor with $5 million in cash spoke to Edward Wedbush, president and founder of Wedbush Morgan, on how to play the financial sector given all the recent turmoil. The prognosis was not good. The upheaval in the industry could go on for another two years, Wedbush told him. And despite the potential for a strong recovery, more banks could still go broke and then fall into conservatorship by the Federal Deposit Insurance Corp.

That investor's question epitomizes the current concerns in the market, Wedbush says. "Most investors believe that the credit extension problem will languish for quite some time, and they're concerned about their life savings in financial institutions."

Yet, there are specific areas of the financial sector that clients could include in their portfolios—even in the midst of a downturn–with minimum pain, Wedbush says.

Specifically, many community banks make excellent investment alternatives, he says, because they have been managed conservatively. One gauge of a healthy bank is that it made conservative mortgage loans, having doled them out with loan-to-value ratios of up to 75%.

Wedbush also expresses a contrarian view, saying that the mortgage giants-the Federal Home Loan Mortgage Corp. and the Federal National Mortgage Association- make attractive buys. Congress passed the Housing and Economic Recovery Act in July. In order to reach its goal of stabilizing the U.S. housing market, the law authorizes the Department of Treasury to make loans and buy stock from Fannie Mae and Freddie Mac, ensuring that they do not collapse. Critics call the legislation a bailout for two institutions that expanded recklessly, but Wedbush believes the move gives Fannie Mae and Freddie Mac an advantage over other lenders.

Since then, Citigroup, Merrill Lynch & Co. and Wachovia Corp. reported combined losses of about $16 billion. Although several banks went on to see their share prices jump about 14% in the immediate aftermath of those announced losses on the idea that the worst was behind them, they have since given back those stock gains. And, in some cases, they've seen their share prices drop even further. Indeed, all that volatility contributed to a belief held by many financial services professionals that they were dealing with a different business paradigm. "Most financial advisors I know about are taking a long-term view for their clients," says Robert Ellis, an analyst for New York City-based research firm Celent. "They're saying: What's different this time?"

Advisors asked that question during past booms and busts, but the basic rules of investing—diversifying and matching risk to client tolerance levels—never change, says Ellis. For the most part, advisors are not recommending drastic moves within the banking component of portfolios, he says. They certainly are not advising clients to get out of the sector altogether, because they cannot afford to do so.

After all, output from the finance and insurance sector accounted for 8% of the nation's gross domestic product last year, according to the Department of Labor. Another reason to stay in? Financial sector stocks are known to pay some of the highest dividends, says Ellis.

The question remains whether the financial sector will have learned from these tough times. "It will hopefully increase disciplines that we need in the extension of credit," says Wedbush. "That applies to individuals and credit card [issuers], as well as the U.S. government."