Diversity Score
Categories: Mutual Funds, Investing
No, not the diversity score that your local college might be keeping track of. In finance, the diversity score of a portfolio tells you have diverse the portfolio is. The diversity score is just a tool that’s made up to give one number to a could-be-complicated portfolio.
For instance, your portfolio might seem balanced since you have a bunch of types of securities—ranging from safe bonds to risk emerging markets, and from big cap to small cap ETFs—but it can be hard to really tell if it’s balanced at a glance. Maybe half of your invested money is in small cap ETFs, and only 1% of your money is in bonds. That’s not so diverse now, is it?
The diversity score wasn’t really made for chump portfolios like yours though (no offense). It was created by Moody’s Investors to handle big-boy portfolios, ones that have CDO’s (collateralized debt obligations) as the CDO market increased in the early 2000s. Only after a handful of years though, they scrapped the diversity score as a tool.
Why would they scrap such a useful tool? Well, would you use a health-o-meter on all your food if all you ate was burgers, fries, and occasionally ice cream? That’s basically what happened. Most CDOs in the early 2000s were lacking in diversity, so they all had bad diversity scores.
They tried to make it fly under the radar, but of course investors and regulators gave a hard side-eye to Moody’s. Annnnnd (spoiler alert)...the 2008 financial crisis happened soon afterwards, which was definitely related to these super-sketchy CDOs.
The diversity score rose like a phoenix from the ashes, and is used today to assess the diversity of assets like CLOs (collateralized loan obligations). While it’s a helpful metric, it definitely has its critics, saying it can make CLOs look lovelier than they are. Always a critic in the house.