What Is a Diversity Score?
In the world of finance, a diversity score is a tool used to measure the amount of diversification that exists among a group of securities. As diversification rises, the risk involved with the securities as a whole generally lessens, so this score, developed by Moody's Investors Service, is extremely important. The diversity score is often used to judge the risks involved with collateralized debt obligations, which are packages of loans that are bought and sold by institutional investors. This score is determined by the diversity of industries included in a group of securities, with a higher score representing a greater level of diversification.
Individual investors and large financial institutions have something in common in the sense that most of these entities are in search of diversity. If diversity is accomplished in a portfolio of securities, the risk involved with the investments is lessened. While one or even a few securities may underperform, diversity ensures that the portfolio as a whole stays strong. One way of measuring the amount of diversity present in a large group of investments is the diversity score.
The main determining factor behind the diversity score is the industry from which a particular security emanates. For an easy example, imagine one investor who has two stocks, one from the technology industry and another from the retail industry. By contrast, a second investor has two technology stocks and nothing else. While the first investor would have a higher score since his portfolio is represented by two different industries, the second investor is exposed to a potential slump in the technology industry and his score suffers as a result.
Moody's Investors Service developed the concept of the diversity score, with the intent that it would provide an accurate measurement for the risk involved with Collateralized Debt Obligations, or CDOs. A CDO is a group of debt securities that are bought and sold in one package. Any CDO possessing a good score is well-diversified and protected from any single industry taking a dive.
There are some drawbacks to using the diversity score to measure risk. The score depends upon the theory of industry correlation, which states that companies in the same industry will tend to perform in the same manner and be exposed to the same risks. In actuality, there are times when industry correlation is far from perfect. To confuse matters even more, sometimes companies in disparate industries can show correlation, meaning that risks might be spread across industries.
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