Harry Markowitz in his Portfolio Analysis introduced into financial analysis the power of diversification. It was a powerful theoretical breakthrough that allowed statistical method to be applied. The Capital Assets Pricing Model of William Sharpe showed that the correlation of the performance of different stocks limited the reduction in risk that could be achieved by diversification. Sharpe introduced the term market risk to denote the risk that could not be reduced by diversification. In the stock market the profits of companies and the prices of stocks may be correlated due to their dependence upon the overall performance of the economy as represented by the level of GDP. The performance of some groups of companies may to correlated due to a mutual dependence on the price of petroleum. Another set of companies may have their performance tied to the price of steel. The price of steel may also be correlated with the price of petroleum thus tying together the performances of the two groups of companies.

The concepts of the reduction of risk can be usefully applied to other markets such as home mortgages. This gave rise to the practise of securitization in which a pool of thousands of mortgages is created and then shares of this pool and its income are sold. In such securitization the risks of default are spread. However, such securitization does not reduce the risk of defaults associated with the price level of real estate. That is the topic of the analysis which follows.

(To be continued.)