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Wednesday's market action offered investors more lessons about managing market risk -- lessons that were remarkably similar to the lessons offered by the market meltdowns on Thursday and Monday. Let's review.

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. And that's what happened Monday, when all 500 stocks in the S&P 500 were down on the day. Wednesday was a slight improvement: only 487 out of the S&P 500 stocks 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 stocks on Wednesday. Granted, some of these stocks (Fannie Mae, most obviously; Citigroup; General Electric, perhaps) haven't been considered defensive stocks for a few years, but others (Wal-Mart, for example) still are characterized as defensive by some investing columnists. In any case, they were all down on Wednesday.

Lesson 3: Hedging Can Limit Market Risk

The screen shot below shows the performance on Wednesday 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.

Flat Wednesday (Didn't Trade)

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. Below is a screen shot of the detailed quote for these puts as of Wednesday's close, which shows that, although they didn't trade Wednesday, an investor could have sold them for at least 21% more than the last trade (the bid price of $4.40 was 21% higher than the last trade price). First, though, 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 20.48% Wednesday

This is the $75 strike put option on SPY expiring in January, 2012. These were the ones we pulled up for an article published on July 29th ("Hedging against a 50% Market Drop"), where we were looking for the optimal puts to hedge against a >49% drop in SPY. Note that the ask price in the screen shot below is $1.28. On July 29th, it was $0.25.

Up 6.53% Monday

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 last Wednesday, "Hedging Widely Held ADRs".

Disclosure: I am long optimal puts on DIA as a hedge.

Source: Lessons From Wednesday's Market Meltdown