The Diversification Index: Why Spreading Income Streams Reduces Risk
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How the Math Works
For each income stream, calculate its share of total monthly income, square that share, and sum the squared shares across all streams. A single stream providing 100% of income produces the maximum concentration score (least diversified); an even split across many streams produces the lowest concentration score (most diversified). Diversification indices typically invert this so a higher number means better spread.
Why Squaring the Shares Matters
Squaring penalizes large shares disproportionately more than small ones — a stream providing 60% of income contributes far more to concentration risk than three streams each providing 20%, even though the totals are identical. This is what makes the measure more informative than simply counting the number of streams.
Using the Score to Guide Decisions
A low diversification score isn't a verdict that a plan is bad — it's a flag to consider whether adding a genuinely different type of stream (not just more of the same type) would meaningfully reduce the portfolio's exposure to any single point of failure.
Frequently Asked Questions
Where does this kind of index come from?
It's adapted from the Herfindahl-Hirschman Index (HHI), a standard tool U.S. antitrust regulators use to measure market concentration among competing firms — the same math works for measuring concentration among personal income streams.
What counts as a 'good' diversification score?
There's no official threshold, but generally, the closer your income is to being evenly spread across several genuinely different stream types, the higher the score and the more resilient the portfolio to any single stream's failure.
Does adding more streams always improve the score?
Only if the new stream doesn't just re-concentrate the same underlying risk — for example, two different dividend stocks are more diversified than one, but still share market risk that a rental property or a royalty stream wouldn't.