How diversification helps when investing for your child's education

Diversification plays a crucial role in investing. However, you must rebalance your portfolio from time to time.

Investing isn't a matter of luck; it requires careful consideration, especially when it concerns your child's education and future. Therefore, it's essential to focus on risk management just as much as we do on potential returns.

What is risk?

As Prof. Aswath Damodaran says, “Risk is a combination of danger and opportunity. You cannot have one without the other."

In finance, risk is categorised into two types: systematic and unsystematic.

Let's illustrate this with a straightforward example: If we had placed all our savings into a single company, such as Yes Bank, we could have faced substantial losses attributed to company-specific risk.

Suppose we had concentrated all our savings into a handful of companies within a single sector, such as online gaming. In this scenario, the company-specific risk would have been minimized. Nonetheless, there would still be a risk of financial loss if the sector encountered challenges, as exemplified when the government implemented a 28 percent GST on online gaming.

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To avoid this, if we had invested our savings in different companies across sectors, the company- and sector-specific risks would have been spread out drastically, despite persistent risks like Covid that hit every company.

Hence, as we allocate our funds across various investment avenues, the associated risk diminishes proportionally. Nevertheless, it's important to note that risk can never be entirely eradicated. The risk that remains despite diversification is referred to as systematic risk, whereas the risk that can be managed by spreading investments across different sectors and asset classes is termed unsystematic risk.

This famous proverb aptly explains diversification: "Don’t put all your eggs in one basket."

Benefits of diversification

As seen above, the first benefit of diversification is risk mitigation. So, while investing in your child’s education, diversification helps spread out the risks and minimise potential losses associated with any single investment. It balances your portfolio, as a decline in the value of one type of investment is offset by the corresponding increase in the value of another.

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The other advantage of diversification is the benefit of economic cycles. Economies go through cycles. Some sectors flourish during a particular period, while others languish. If your portfolio is well diversified, you have exposure to both the booming sector and the one going sideways. Hence, you get at least some benefit from the bull run.

How to diversify?

Mutual funds are one of the best ways to diversify one’s portfolio. Since mutual funds invest in multiple companies and not just one, you get exposure to a basket of firms. An excellent way to diversify the portfolio through mutual funds is to invest in different categories of funds according to one’s risk appetite. A balance of debt and equity can help mitigate risk. A multi-asset mutual fund scheme exposes you to multiple asset classes like equity, debt, gold, etc.

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How much to allocate to equity, debt, hybrid funds, etc., will depend on an investor’s risk tolerance. One’s life stage affects the ability to take risks. The younger we are, the greater the risk we can take, and the more we can allocate to equity.

For example, if you are investing for your child's graduation and have 10-12 years in hand, allocation to smallcap, largecap, flexicap funds, etc., will be appropriate. As the time in hand shrinks, the risk-taking ability also reduces, and allocation to hybrid and debt funds is recommended. Therefore, it is vital to rebalance the portfolio from time to time.

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Conclusion

Diversification plays a crucial role in investing. However, you must rebalance your portfolio from time to time. This is a good way to create a solid corpus for your child’s education.