The Bucket Approach

In my mind, the word ‘bucket’ should be banned from the investment industry because it brings to mind the ‘bucket shops’ where unlicensed hacks in boiler rooms cajole unwitting investors into pump and dump schemes.

Despite my view about this word in this industry, it seems to be what we as a group have settled on for a particular retirement planning strategy (I’m not a fan of smart beta either, as outlined here).

The basic idea behind the ‘bucket approach’ is that investors should maintain three buckets, one for short-term living expenses that’s extremely safe, one for securities with an intermediate-term that are a little riskier and provide a little more return and one for long-term assets that is very risky but you expect to grow.

That’s right, the bucket approach calls for a cash, bond and stock portfolio, but instead of thinking about them as pieces of a pie chart, it ‘unfolds’ the pie chart and asks you to think of your portfolio in a linear fashion.

The first bucket is simply cash.  The cash covers your immediate needs, which is usually about a year’s worth of expenses.  No matter what the market is doing, it’s always sitting there, safe, liquid and ready to go.  If the market tanks, you’ve got nothing to worry about because the money you need over the next year is totally safe.

The second bucket covers the next nine years of expenses and gradually steps out on the risk spectrum and is usually invested in bonds. It’s not as liquid or as safe as the first bucket, but it should also keep pace with inflation.

When your time horizon is one-year like the first bucket, inflation won’t do as much damage, but even at three percent, inflation will erode your purchasing power by 25 percent over 10-years, so the second bucket needs to keep up, which requires a little risk taking.  Like the first bucket, if stocks are tanking, this bucket should be holding up just fine, so you don’t need to be worried.

The third bucket is made up of stocks, which is the growth engine of your portfolio. As we all know, however, the growth is so uneven that it has included two 50 percent plus drawdowns in the last 20 years and was down 90 percent in the Depression.

Of course, even with these disastrous periods (and other ones too), they’ve still managed to knock out returns of 10 percent on average since 1926, which obviously means that there have been some pretty good runs in there (like we’ve had since 2009).

During good stock market years, you can take money from bucket three and fill up buckets one and two.  During the lean stock market years, you can hold off and draw into buckets one and two for living and keep your money invested in the stock market.

Sounds like a good idea, doesn’t it?  It is a good idea, actually.  So, why doesn’t Acropolis use the bucket approach, other than the lousy name, since I’m sure our clever marketing folks at Simply Strategy could come up with a smart alternative?

First off, sometimes we do use the approach, but the thing to remember is that, sometimes, it’s really just a way to talk and think about the portfolio and the management is largely the same.

A second issue is that the bucket approach usually calls for a much larger cash allocation than what we recommend.  Our financial planning software allows you to use the bucket strategy and I’ve found that it generally reduces the chance of meeting a client’s goals by one or two percent.

If you think about it, that makes perfect sense because you’re lowering the expected return of the portfolio by increasing the cash allocation. However, for the client’s that I’ve tested, the difference wasn’t very large, so if it helps a client think about their portfolio and stay invested during periods of stress, it’s totally worth lowering the expected return (because bailing out at the wrong time really lowers the expected return).

Of course, how much the expected return declines is completely a function of how much the anticipated expenditures are compared to the size of the portfolio.  For smaller investors, the larger cash allocation could change the expected return dramatically and have a greater impact on the odds of meeting their goals.

Wealthy clients could have the opposite problem: if buckets one and two cover 10-years’ worth of expenses and bucket three puts everything else in stocks, it’s quite possible that someone with a lot of assets relative to their net worth would end up with a very stock-heavy portfolio.

It’s not outrageous to imagine a circumstance where the bucket strategy calls for a 90/10 stock bond mix if an investor’s net worth were 10 times their anticipated expenses.  That portfolio could be wildly inappropriate for a conservative investor that can’t suffer the drawdowns associated with such an aggressive portfolio, regardless of the fact that 10-years of expenses are covered.

Again, I think the bucket strategy makes sense for some people.  But, like most things that we do, there’s no ‘one-size-fits-all’ approach.  And since the bucket strategy is mostly psychological, we think we’re dealing with that on a one on one basis with each client in the way that they need to cope.

Thankfully, it’s been a long time since we’ve had to deal with major losses.  As always, I can’t say when the next downturn is coming, how long it will last or how deep it will be, but I do think that we’re as prepared as we’ve ever been, thanks in part to the strategies that we’ve employed over the last decade, which, in case you’ve forgotten, have been both up and down.