There are some smart money moves to make when the stock market is volatile, but it can also be a time of uncertainty for many investors. Many people start looking for strategies to manage their portfolios in a way that allows them a little peace of mind, and still offers the potential for growth down the road.
One way to manage your portfolio is to use what’s known as the bucket strategy. With this strategy, you divide your portfolio into buckets designed for different purposes. The bucket approach is particularly useful for retirement planning, but it can also help you work toward plenty of other financial goals.
I’ve used bucket strategy investing with my own portfolio and find it provides me with limited protection against a down market, as well as still offering the potential for growth.
What is the bucket strategy?
In general, bucket strategy investing is about dividing up your portfolio based on time horizon, or how soon you’re likely to use the money. It’s fairly common to divide the buckets into money you’ll use in the short-, medium-, and long-term.
The three buckets in this strategy typically look like this:
- First bucket: This is money you think you’ll need in the next two to five years. It should be relatively liquid and easy to access. Cash, high-yield savings accounts, money market accounts, laddered CDs, and other highly liquid investments should be considered for this bucket.
- Second bucket: If you don’t think you’ll need access to this money for at least five to eight years, you can keep this portion of your bucket portfolio in assets that are considered income-generating. Bonds are often kept in the medium-term bucket. Some investors like to keep dividend stocks, such as dividend aristocrats, in the medium-term bucket.
- Third bucket: Finally, if you know that you won’t access the money for at least eight to 10 years, keeping it in stocks can allow you to take advantage of potential growth. This is likely to be the largest of your buckets as the bulk of this money probably won’t be needed until later in life, like retirement.
To set up the bucket strategy for yourself, you could liquidate your existing shares of stocks that have gained. You’re selling those stocks at a higher price than when you purchased them, and you’re putting that money into the cash bucket. You can also use this method to buy into lower-priced bond funds and dividend stocks to keep in your medium-term bucket.
Once your buckets are set up, you will periodically need to do some rebalancing. Usually this means refilling the short-term and medium-term buckets using growth gained from the long-term bucket, which is more likely to benefit during market recoveries. Every so often (on a schedule that makes sense for your situation), you review the buckets and pour assets from one to another to ensure your asset allocation is appropriate for your personal finance goals.
Although you might need to set up your buckets during a time of market volatility, you’re likely to see better results when the stock market is relatively high and you can sell some of your investments at a gain.
The psychological benefit of bucket strategy investing
I like the bucket investment strategy because it provides a measure of protection during a bear market while not requiring you to liquidate all your investments and risk missing out on the benefits of an economic recovery.
Because a bear market is a period when stocks are mostly falling, many people worry about the value of their portfolios. This is especially true for new investors or those who have a lower risk tolerance and who are nervous about losing a big chunk of their savings. Additionally, those who need to access some of their assets, such as retirees or those nearing retirement, can feel nervous during a market downturn.
When you have to liquidate some of your stocks when the market is down, you have no choice but to sell at a loss. A strategy called tax-loss harvesting can help you deduct your losses at tax time. Although tax-loss harvesting can take away some of the sting, it’s still not an ideal situation for many. Plus, if your money is in a tax-advantaged account like an IRA, you won’t be able to use tax-loss harvesting on those losses.
How the bucket strategy works
Toward the end of 2019, I started getting nervous about the market. My son’s 529 account was entirely in stock index funds, and I was worried there might be market turmoil that would reduce his school funds before he started college.
In order to reduce my concerns, I implemented a bucket system:
- I figured out how much money my son would need for three semesters of college. I sold the equivalent amount of stocks (for a profit) and used the proceeds to purchase shares of a money market fund.
- Then, I figured out how much money he would need for the following three semesters and sold the equivalent of stock funds and used those proceeds to buy shares of bond index funds.
- I left the rest in stocks, and hopefully, by the time they’re needed, there will be a bull market.
Knowing that I won’t have to sell off stocks at a loss during a stock market crash allows me to feel a sense of peace. Plus, because I still have money in stocks, I know I can benefit from an economic recovery in the future. You can use the bucket strategy to plan for your child’s education like I have, or this approach can work for creating a retirement portfolio as well.
Many retirees worry that the combination of higher healthcare costs and longer lifespans mean they can’t move all their money to income investments (like short-term bonds) and cash when they retire. In fact, one of the costly retirement mistakes is selling stocks at the beginning of a crash and then locking in those losses. The bucket strategy can give retirees a way to access a portion of their portfolio when needed while still maintaining growth that can support them if they live longer and have more years of retirement to support than originally planned.
Most online brokers will allow you to create a portfolio mix that allows you to use a bucket approach to your investing. When it comes to how to choose a brokerage, if you’re planning to use the bucket strategy, you’ll want to pick one that supports your goals.
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How to succeed at bucket strategy investing
- Make a plan. Spending some time doing financial planning is essential to a successful bucket strategy. Create an investment plan based on your priorities and potential needs. Know when you’re likely to use the assets. If you’re not sure how to do this, consider speaking with a financial planner.
- Rebalance as you go. Don’t forget to pour assets into other buckets. For example, after my son gets about halfway through the first cash bucket, I’ll do some rebalancing. I’ll refill the cash bucket using the returns from the medium-term bucket. Then, if needed, I can pour assets from the long-term bucket to top off the medium-term bucket.
- Consider keeping your buckets in a tax-advantaged account. Although the bucket strategy can work if you’re using taxable investment accounts, you have to account for capital gains and losses when you rebalance your buckets. When you keep your money in a tax-advantaged account, such as a 529 or a IRA, you can avoid a tax bill each time you make a move. Plus, with a 529 or a Roth IRA account, you don’t ever pay taxes on your gains.
- Stick to the plan. The point of the bucket strategy is to make sure you have access to cash equivalents to use during times the market is down. This ensures there’s less of a chance you’ll end up selling stocks at a loss. If you change your plan in the middle, you run the risk of messing up the system.
Whenever you’re concerned that a bear market might mess up your ability to make the most of your portfolio, a bucket strategy can help.
You don’t want to put too much money into cash because it won’t offer the level of returns you see with other assets. Using bucket strategy investing can ensure that you have access to cash, and that your stocks and riskier assets continue to earn higher returns and benefit from the market recovery that usually follows a crash.
Remember, though, that learning how to invest money comes with the risk of loss. There’s still a slim chance the market will not recover on a timeline that aligns with your financial needs or goals.
It’s fairly easy to set up a bucket strategy using many of the best investment apps. However, if you feel overwhelmed by the process, you can talk to a personal finance professional or financial advisor who can help you plan your strategy and stay on track.
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