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Thursday's market action illustrated a few lessons about managing market risk.

Lesson 1: Diversification Doesn't Protect Against Market Risk

Diversifying among a basket of different stocks reduces idiosyncratic (or, stock-specific) risk, but not market risk. When the market tanks, nearly all stocks get hammered. That’s what happened on Thursday, as 497 of the stocks in the S&P 500 were down on the day.

Lesson 2: Defensive Stocks Don't Protect Against Market Risk

This is a point Seeking Alpha contributor Sy Harding made in an article a few months ago, titled "Don't Fall for the 'Defensive Portfolio' Hype", and it bears repeating:

The failure of defensive stocks to protect portfolios has been demonstrated over and over again. But the advice remains the same in every cycle.

After the market seemed to top out in the year 2000, the stocks most recommended as defensive stocks included Alcoa (NYSE:AA), Bristol Myer Squibb (NYSE:BMY), Citigroup (NYSE:C), Coca-Cola (NYSE:KO), Disney (NYSE:DIS), DuPont (NYSE:DD), Fannie Mae (OTCQB:FNMA), General Electric (NYSE:GE), Home Depot (NYSE:HD), IBM (NYSE:IBM), Merck (NYSE:MRK), and WalMart (NYSE:WMT). However, they plunged an average of 59% to their lows in the 2000-2002 bear market, worse than the Dow's decline of 38% and the S&P 500 decline of 49%.

The screen shot below shows the performance of each of those defensive stocks on Thursday.

Lesson 3: Hedging Can Protect Against Market Risk

The screen shot below shows the performance of the SPDR S&P 500 Trust ETF (NYSEARCA:SPY), the SPDR Dow Jones Industrial Average ETF (NYSEARCA:DIA), and a few put options on them that I have alluded to in recent articles. More on those below.

Up 74.77% Thursday

This is the $98.75 strike put option on DIA expiring in December, 2011. In recent articles, I've mentioned in the disclosures that I am long puts on DIA as a hedge. Those are the specific DIA puts I own. In late June, I used Portfolio Armor to find the optimal put options to hedge against a greater-than-20% drop in DIA, and those were the ones Portfolio Armor presented. The screen shot below shows the quote for them as of Thursday, but first a quick reminder about optimal puts.

About Optimal Puts

Optimal puts are the ones that will give you the level of protection you specify at the lowest possible cost. As University of Maine finance professor Dr. Robert Strong, CFA has noted, picking the most economical puts can be a complicated task. With Portfolio Armor (available on the web and as an Apple iOS app), you just enter the symbol of the stock or ETF you're looking to hedge, the number of shares you own, and the maximum decline you're willing to risk (your threshold). Then the app uses an algorithm developed by a finance PhD to sort through and analyze all of the available puts for your position, scanning for the optimal ones.

Up 23.08% Thursday

This is the $75 strike put option on SPY expiring in January, 2012. These were the ones we pulled up Friday when we were looking for the optimal puts to hedge against a >49% drop in SPY ("Hedging against a 50% Market Drop"). Note that the ask price in the screen shot below is $0.50. A week ago, it was $0.25.

Up 47.5% Thursday

This is the $104 strike put option on SPY expiring in March, 2012. This was the SPY put option we referred to for comparison purposes in an article Wednesday, "Hedging Widely Held ADRs".

Source: Lessons from Thursday's Market Meltdown