If you're like millions of other American investors today, you're probably a "bucket investor."
Most likely, you have some money in a retirement account, another pile in a college savings fund and a third stash set aside for emergencies. If you're a retiree, you may have a cash bucket for expenses for the next three to five years plus an investment bucket for long-term growth.
Putting your money in buckets has become a popular planning tool for investors and financial advisers alike — nearly a third of financial professionals now use some variation of the strategy for their clients, according to the Financial Planning Association.
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There's one main reason planners like it. Since bucketing can provide peace of mind, it helps keep investors on track. If you have three years of expenses set aside in cash, you're less likely to rush for the exits if the stock market tumbles, says Michael Kitces, director of research for Pinnacle Advisory Group in Columbia, Md.
Another plus: It turns out human brains are wired for this kind of "mental accounting," Kitces notes. According to behavioral finance studies, we have a tendency to tie our investments to certain goals or time periods and then treat each of the investments differently.
Sure, stocks and funds are "fungible," easily switched from one bucket to another. But it may be easier to stick with your goals if you know each bucket has a specific role to play in your financial plan.
While the strategy can sound appealing, it has drawbacks. Some research suggests that investors who maintain a large cash bucket would actually fare better with a standard investment mix such as 60% stocks, 35% bonds and 5% cash that's rebalanced periodically.
Investment buckets, in this view, probably lower total returns, meaning you leave some money on the table or, worse, you run out of money in old age. Buckets for your 40s and 50s
If you're 40- or 50-something you probably have distinct goals with different time horizons. Saving for retirement may be your main objective — say, 20 years away. An intermediate goal is often saving for college. And you may hold some money in cash for a pending house purchase or as an emergency fund.
For these investors, creating buckets tied to each goal makes perfect sense, says Kitces. "It's very reasonable that each time horizon would have a different asset allocation. If you need 90% of your money in two years it should be 90% in cash."
In fact, most people do this automatically: holding most of their retirement savings in a 401(k) or IRA, for instance, and cash in a savings or money market account. For the retirement bucket, advisers generally recommend a healthy dose of stocks.
Mitchell Reiner, an adviser with Wela Strategies in Atlanta, suggests holding 85% of your retirement funds in stocks if you have at least 15 years, noting stock returns tend to trounce bonds and cash over the long run.
Indeed, the S&P 500 (.SPX) averaged a 9.3% annual return from 1928 to 2012, according to data from NYU finance professor Aswath Damodaran. Ten-year treasury bonds averaged a 5.1% return and cash invested in 3-monthTreasury bills returned 3.6% a year, his data show.
For an intermediate-term goal — say 10 years away — many advisers suggest a more conservative mix of roughly 60/40 stocks and bonds. Balanced mutual funds tend to hold that mix. Target-date funds can also play that role in a retirement account — gradually becoming more conservative as your retirement approaches. If you're saving for college, most 529 plans offer balanced or target-date funds as well.
As for the cash bucket, Reiner suggests keeping it low. An emergency fund should hold three to six months of living expenses if both spouses are working. Reiner himself holds 12 months of expenses to be on the safe side.
However you go, it's important to think of your portfolio holistically, especially when it comes to taxes. Fixed-income investments like bond funds should generally be held in tax-deferred accounts like an IRA or 401(k), notes Reiner, while individual stock holdings or stock funds outside an IRA or 401(k) should usually go in taxable accounts since they should generate relatively little taxable income. Other factors should be taken into account as well, adds Reiner, including required minimum distributions from a traditional IRA or 401(k) and estate planning, impacting which accounts to draw down first.
Index funds or ETFs tend to be more tax efficient than actively managed funds, especially if the active funds generate a lot of short-term capital gains. An adviser can help you figure out the best tax strategy for all your accounts. Bucketing for retirees
Retirees face a different situation, often with two objectives to reconcile: maintaining a current stream of income and managing "longevity risk."
On the surface, bucketing may look appealing. For example, say you have a $1 million portfolio at age 65 and plan to withdraw 4%, or $40,000, a year. You might stash $120,000 in a money market fund to cover the first three years of expenses. A second bucket might be held in fixed-income investments for years 4 through 10 of retirement. A third bucket may hold stocks for years 11 through 30.
The approach offers a bit of psychological security for people worried about market ups-and-downs, says Kitces. If a bear mauls the market early on in your retirement, you can rest easier knowing you have enough cash set aside to pay bills, travel and meet other spending needs.
That added security can help investors stay in stocks for the long haul, which is far better than panicking and selling at a market low — a tactic almost certain to hurt your portfolio in the long run.
"We have 150 years of history that stocks recover from bear markets," says Kitces, "yet people still sell at the bottom."
But bucketing your investments with a large cash buffer may not be ideal either. For starters, in the example above, only 88% of your portfolio would be invested, which can lower your long-term returns. If you exhaust your cash account and stocks are at or near a bear-market low, you may be forced to sell some stocks at a bad time. If you choose to sell bonds instead, you'll raise your stock exposure — and your portfolio's risk.
"All else being equal, if you're trying to meet your retirement goals with 88% of your portfolio, you'll have less success" than if you stay fully invested, says Kitces.
In fact, some research suggests cash buffers may do more harm than good over long periods. A 2012 study in the Journal of Financial Planning analyzed stock and bond portfolios with different asset mixes, withdrawal rates and time horizons. The portfolios also included cash buffers covering withdrawal rates from 3% to 9%.
The conclusion: In most market scenarios, the portfolios without the cash buffers were more likely to allow investors to sustain their withdrawal rates, regardless of asset mix or time horizon.
Granted, with a low withdrawal rate of 3% "it doesn't really matter whether one uses buffer zones," the authors wrote. But "the higher the withdrawal rate, the more damage occurs with the use of buffer zones." Higher withdrawal rates require more growth, they added, and holding more cash impedes that growth. Alternatives to bucketing Rather than holding a large bucket of cash, Kitces suggests putting almost all your retirement funds in stocks and bonds and rebalancing your portfolio regularly.
If you're nervous about the markets, you could set aside cash to last three to six months or however long your rebalancing cycle lasts. As you rebalance, investments that are up will be sold, reallocating to those that are down and helping to replenish your cash needs. In essence, this is the same as a systematic withdrawal plan, in which shares of stocks or funds are sold automatically every few months to generate cash.
That strategy should help maintain your targeted returns over the long run, he says, and provide enough cash at your target withdrawal rate since you'll be selling stocks or bonds periodically. You'll also avoid holding so much cash that your long-term returns suffer.
Daren Fonda is Senior Writer and Investing Columnist with Fidelity Interactive Content Services, a provider of objective investing content on Fidelity.com. He does not own any of the securities mentioned in this article.