Ouch.

It has been quite some time since the Dow dropped over 500 points in just a few hours. The last time it happened, the biggest terrorist attack in our nation’s history was the culprit. This time, we had only the vague notion that the Chinese government is concerned enough about stock market speculation and their economy, to rattle our stock markets.

How could such a relatively minor event lead to over a trillion dollars in global stock market value vanishing within hours? Remember, when the head of our own Federal Reserve — a far more powerful figure to the global economy and stock markets than the Chinese heads of state — uttered his now infamous “irrational exuberance” zinger at a dinner lecture in December 1996, the markets didn’t even skip a beat.

As the dust settles, experts will reassure you that nothing has fundamentally changed since the day before the mini-crash. But pundits are always most likely to tell you to stay the course when stocks are high. Back in 2002, when the Dow was below 8,000, “buy the dips and hold tight” was not a common recommendation- but it was in 2000. 

In fact, something has changed — investors are no longer just looking down, they’re looking up as well. Stocks have been almost unnaturally stable over recent years, moving around with historically low up- and down-swings. The current trailing standard deviation (a statistical measure of dispersion) on the S&P 500 is as low as we’ve ever seen it. The CBOE Volatility Index – or VIX – which is a measure of expected stock market volatility by looking at option premiums has been falling for about five years straight.

If you look at a one-year chart of a hot ETF (exchange traded fund) like the iShares FTSE/Xinhua China (FXI), you’ll see how it would be pretty easy for an investor to get wrapped up in all the excitement, like Wile E. Coyote charging after the Road Runner, . But, remember, when Mr. Coyote is going full speed ahead, chasing performance, he doesn’t realize he has left the sound footing of the earth a few steps behind. Even though there is nothing fundamentally supporting Mr. Coyote, everything is always just fine… until he looks down. That’s when the sharp drop commences.

On February 27th, investors looked down. They didn’t like what they saw.

So, what if the Chinese economy slows? What if demand for commodities slips? What if the U.S. economy slows like Mr. Irrational Exuberance himself said could happen later this year? Maybe stocks in a communist country, with elevated political and financial risks, shouldn’t trade at richer valuations than similar stocks in the U.S. Until today, investors focused on potential growth. Now they are looking at potential drops as well.

Hot returns always attract attention. So far, only two short months into 2007, mutual fund investors have poured over $40 billion into stock funds — much of it into overseas and emerging market funds. Unfortunately, fund investors have a habit of getting most excited about a particular investment just before the good times end.

In fact, despite their unprecedented growth in recent years, dozens of mutual funds and ETFs fell between 5% and 10% in this week’s mini-crash. Some leveraged funds fell almost 20%. Worse yet, every market fell. There was no safety to be found in diversified portfolios, with money spread into different sectors and stock markets; they all fell this week, and they all fell hard. Even if your money had been invested across every single one of the hundreds of new ETFs launched in the last few years, you would have still lost money, no matter your holdings. 

This week’s free fall adds another layer of fear to today’s investor portfolios- many were mistakenly under the impression that the reason they lost money in the 2000-2002 bear market was lack of diversification, all U.S. large cap tech and growth, and no small cap and global value meant all work and no play. The mini-crash shows us just how you can’t always diversify away your downside risk in stocks so easily anymore – at least now that almost everything is in favor. 

What investing pundits don’t always tell you is that diversification only works when all asset classes are not equal- at least, not equally priced. When everything is in favor, investors need cash- money market holdings and short term bonds- to lower overall portfolio risk.

As fear sinks in, expect higher risk assets to lose their luster. This includes emerging markets (stocks and bonds), high yield (junk) bonds, international stocks in general, and REITs (which used to be low risk, until they rocketed up in price).

Eventually we’ll get another opportunity to buy higher risk assets on the cheap in our higher risk model portfolios and a chance to benefit when they run. It’s always a good thing when investors get rewarded for taking on higher risk.