There are many ways to approach asset allocation, but honest evaluation of goals and risk tolerance should paint a broad picture of a portfolio’s priorities. Every investor is an individual with different needs and timelines. While some are focused on preserving retirement income, others seek aggressive yield on returns. The majority require a customized variety of funds to balance security with growth. Categorizing holdings according to larger goals or “buckets” is one way to keep investment goals on track through volatile spells and offers investors a simple investment plan model.
Allocating Assets
When it comes to general asset allocation, most investors start at the top, considering age, risk tolerance and desired return, followed by sector exposure, foreign exposure, risk and yield, to ultimately drill down to a decision about which individual funds to hold. This is a solid approach that works for many people. Rebalancing is straightforward, and portfolio withdrawals are based on a fixed amount or percentage of the portfolio, generally using a systematic rule such as a variant of the hotly debated 4 percent withdrawal rule.
Pension funds take a liability-responsive asset allocation approach, breaking down their investments in terms of liabilities. They pay money to current pensioners, prepare to pay people nearing retirement and plan to pay into the future as necessary. Pension funds take on more risk and hold a large share of equities, so for workers nearing retirement, these funds need to shift into more conservative, income-generating assets. For current pensioners, the pension fund needs to protect the value of the assets it may need to sell to meet its obligations.
Individual investors can take a similar approach when allocating personal assets. An investor’s current liability is money needed in the next few years and should never be placed at risk. More risk can be taken with 10-year assets, but the investor should still use caution in the event of a bear market. Money that won’t be needed for at least 15 years or perhaps is intended for heirs can be more aggressively invested.
The three portfolio segments described above are sometimes referred to as buckets. The first is the cash bucket, the next is the intermediate-term bucket and the last is the long-term bucket. They could also be described as the low-, moderate- and high-risk buckets.
Using this approach, an investor will first consider the cash bucket. Immediate expenses over the next two to five years are allocated here. The money is invested in savings accounts, money market funds, CDs and/or short-term Treasuries. A special account may be designated for these assets.
The next bucket is for money needed over the next 10 years. Instead of cash, an investor might hold intermediate-term bonds, corporate bonds and higher-yielding bonds.
The third bucket contains higher-risk assets such as equity funds. When allocated appropriately, this is the category likely to see the greatest amount of growth, especially when it is carefully monitored and managed.
Benefits
Determining how much income is needed and separating those assets can go a long way toward reducing the emotional impact of volatile markets. Using the bucket approach to allocation can help investors focus on the holdings themselves instead of the overall portfolio return. Watching a portfolio drop 10 percent in a bear market might be nerve-racking for an investor worried about near-term expenses, but the same investor may be able to stomach it better when seeing the portfolio broken down into buckets, with no loss in the cash bucket, a small loss in the second bucket and large losses in the third bucket. Even though the total value will drop the same amount as would a single account, breaking holdings into separate accounts may be a useful tactic if it brings peace of mind.
Costs
While investment buckets can make sense as a way of thinking about your assets, putting a bucket strategy into practice has costs. Assets need to be shifted between buckets (accounts) as time passes. Asset rebalancing is complicated by the need to shift assets across accounts. Maintaining discipline is the key to successfully implementing the bucket strategy.
Furthermore, cash withdrawals are easier to manage in a single account. A single account can be rebalanced without having to transfer assets, which may be impossible if some assets are in tax-deferred accounts. Many investors have multiple accounts – perhaps a savings account, a brokerage or fund account, a traditional IRA, and a Roth IRA. Managing three buckets across four or five accounts can become unwieldy over time.
The biggest cost for investors may be the complexity, including maintaining a balance between the accounts over time and preparing for surprises. If you have an emergency and need extra cash, from which bucket do you sell assets? Are you constantly depleting your cash bucket, or is it more of an emergency reserve that is seldom tapped? Many investors already use something akin to the bucket approach with their accounts due to tax efficiency. An IRA can’t be tapped penalty-free until retirement, and a Roth IRA has no required minimum distributions. In light of this advantage, some investors place long-term assets into their Roth, since they are least likely to be sold. Some investors prefer to place high-yielding and tax-inefficient mutual funds in their tax-deferred accounts to lower their tax bill, while holding long-term, tax-efficient equity funds such as ETFs in their taxable accounts. Breaking the portfolio into buckets adds another layer of complexity to these considerations.
Conclusion
Breaking your portfolio into buckets is a simple allocation approach. It aligns risk with time, with your shortest-term capital in the lowest-risk assets and your long-term capital in the highest-risk assets. You may find your portfolio has too much risk and not enough cash, but you may also discover you’re worried about assets you don’t plan on touching for 15 years or more. Managing your money in buckets may be taking the next step, but it is a much larger step and one that requires diligent planning. For more information about our investment strategies, call us at (888) 252-5372.