The strategy was sound, provided only a few used it at once. But by midsummer 1987, portfolio insurance had become as ubiquitous as hair-metal music. Many people, driven by the same computer models, were placing almost identical bets. Rob Arnott, a well-known value investor who, in 1986, wrote a seminal article for Pensions & Investment Age that warned against the technique, says the amount of money invested with the strategy hit about $90 billion, or as much as 10 percent of all pension assets, that year. By comparison, the value of volume traded daily on the stock market was about $4 billion.

On the morning of Monday, October 19, after several rocky weeks, money managers using portfolio insurance came into the office needing to sell stocks. Because everyone was moving in the same direction, the New York Stock Exchange’s clunky trading system locked up. As stocks fell, more futures needed to be sold, pushing the stock market down and creating a ­vicious cycle. Mix in a dash of panic, and a strategy intended to be anodyne ended up causing searing pain.

Old Wall Street guys love talking about the 1987 crash—from this distance. Jeremy Grantham, chairman of the Boston money-management firm GMO, describes the period as “the most exciting days of my professional life.” Grantham, a value-investing icon and noted bear, told me he was in an investment meeting the Friday before the crash, urging a college endowment to hedge against a potential drop in the market and to do so right away. For technical reasons, the hedge was never put in place, and the crash hit the endowment much harder for the lack of it.

By the standards of today’s credit-default-swap and collateralized-debt-obligation-filled marketplace, portfolio insurance was almost laughably crude. Unlike current complex investment strategies, portfolio insurance, which was limited to stocks, was unusually concentrated. Investors now are “less focused on a single type of strategy that trades in a specific way,” says Arnott. But the lessons of that debacle remain pertinent. “While the kind of portfolio insurance practiced in 1987 is extinct, today there is portfolio insurance in disguise,” he says.

Now investors in the bond market use a different insurance strategy, called credit-default swaps, that employs instruments untested by crisis to protect bondholders against loan-repayment problems. The C.D.S. market, which had a $28 trillion value by the end of last year, provides useful protection and risk-spreading for investors—provided the seller can make the C.D.S. payment in case of default.

Similarly, defensive strategies devised by banks and hedge funds have also backfired in recent months, showing how even the most ingeniously complicated Wall Street concoctions can turn on their users. Banks sought to hedge their potential exposure to bad loans by betting against the LCDX, a recently created index that falls when fear of loan defaults rises. At the same time, hedge funds and investment banks sought protection through another recently created index, the ABX, which serves as a proxy for subprime mortgages.

Then an odd thing happened: Both of these insurance tactics unexpectedly crumbled. As investors and banks used these indexes to hedge, the selling put downward pressure on them. Since the underlying securities don’t trade much, the indexes serve as a benchmark for pricing them. Seeing these instruments fall, creditors demanded more collateral from those holding the securities. That led to selling, as the holders had to unwind positions to come up with the collateral. In other words, it was a repeat of 1987: The hedging instruments brought about the very thing they were supposed to prevent. “The very act of people acting in the market changes the nature of the market,” says Wall Street veteran Richard Bookstaber, author of A Demon of Our Own Design, an I-was-there study of recent financial calamities.

This summer, as in the fall of 1987, crowding in one specific strategy hurt investors. Quantitative hedge funds, which use sophisticated algorithms to make huge numbers of rapid-fire market bets, found that they had picked out precisely the same securities to buy and sell short (bet that they would fall). When quant funds’ holdings started falling, buyers were forced to reduce their exposure by selling more of the stocks they owned and buying more of the stocks they shorted.

Some of the most precious creations of Wall Street’s beautiful minds—Renaissance’s James Simons, Goldman Sachs’ Mark Carhart and Raymond Iwanowski of its Global Alpha hedge fund, and AQR's Cliff Asness—took their lumps. Asness wrote in a letter to clients during the tumultuous days of August, “Our stock-selection investment process, a long-term winning strategy, has very recently been shockingly bad for us and for all of those pursuing similar strategies. We believe that this has occurred as the very success of the strategy over time has drawn in too many investors.” Quant funds were forced to reduce their exposure by taking on less derivative-fueled leverage. Leverage doesn’t distinguish between I.Q.’s; it brings its magic and its pain to the smart and stupid alike.