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Ouch.

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

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

As the dust settles you’ll be reassured by experts that nothing has fundamentally changed since the day before the mini-crash. What a great buying opportunity for the brave — to buy at a discount from the weak-kneed. In fact something has changed — investors are now looking down as well as up. Stocks have been almost artificially stable in recent years, with stocks moving around with historically low up and down swings.

If you look at a one-year chart of a hot ETF 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. When Mr. Coyote is going full speed ahead chasing performance, he doesn’t realize he left the sound footing of the earth a few steps back. Even though there is nothing fundamentally supporting Mr. Coyote, everything is 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.

What if the Chinese economy slows? What if demand for commodities slips? What if the U.S. economy slows like Mr. Irrational Exuberance himself just said could happen 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 sink.

On my fund investing website MAXfunds.com investors can sift and screen over 20,000 funds. In the 72 hours before the mini-crash, one of the top five most viewed fund pages was a China fund, Oberweis China Opportunities Fund (OBCHX). Hot returns attract attention. So far in 2007 mutual fund investors have pored over $40 billion into stock funds — much of it into funds investing overseas and in emerging markets. Unfortunately, fund investors have a habit of getting most excited about an investment area shortly before the good times end.

Back in 2000 the top searched for funds on our site invested in tech, growth, and Internet stocks. Investors then and today were playing a game of investing musical chairs. Eventually, the music stops and investors are left scrambling for a chair. During the mini-crash that chair was safe U.S. government bonds.

Dozens of mutual funds and ETFs (exchange traded funds) fell between 5% and 10% in the mini-crash. Some leveraged funds fell almost 20%.

Worse, every market fell. There was no safety diversifying your portfolio into different sectors and stock markets. Even with your money invested across every single one of the hundreds of new ETFs launched in the last few years you would have still lost money. This adds another layer of fear to today’s investors: many were under the impression that the reason they lost money in the 2000-2002 bear market was lack of diversification, all U.S. tech and no global value. The mini-crash proves you can’t diversify away your downside risk in stocks so easily anymore.

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). Expect the conundrums in the market to fade, like why are junk bonds trading at premium levels while bonds in general say the economy will slow soon?

Relatively safe investments in each asset class should perform well in 2007. This means low fee money market funds like Vanguard Prime Money Market (VMMXX), short and intermediate term investment grade bond funds like Vanguard Short-Term Investment-Grade Fund (VFSTX), and U.S. larger cap growth stock funds like Vanguard U.S. Growth Fund Investor Shares (VWUSX). Keep in mind stocks funds are always risky.

Eventually you’ll get another opportunity to buy higher risk assets on the cheap. It’s a good thing, getting an actual reward for taking on risk.

Jonas Ferris is a regular contributor to "Cashin' In" and is co-founder of MaxFunds.com.

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