Filling a gap

THE magic of portfolio theory applies wherever there is risk—whether in the stockmarket or in the “market” for floods, earthquakes and so on. In simple terms, it amounts to this: risk gets cheaper when mixed with other, uncorrelated risks. Say that a dollar of capital must be set aside as a safeguard against one unit of fire risk. In a portfolio of 100 units that are far enough apart not to be burnt by the same fire, each unit might require only 90 cents; in one of 1,000 risks, 70 cents, and so on. The larger the portfolio, the more capital is freed up.