Allocating funds to achieve financial goals- Buckets of Money
Before considering any specific investments, we need to set up an overall financial strategy. How should we allocate savings to achieve a variety of goals? The concept of allocating different “buckets” of money to different financial goals provides a useful starting point. Since everyone’s needs and attitudes towards risk differ, there is no standard recommendation for the percentage of money that should fall into each bucket. The different buckets of money do not have to represent distinct accounts; they may represent different portions of a single brokerage account.
Bucket 1- Safe Money Bucket = Emergency Fund
This should be the initial building block of an individual’s financial plan. Safe money provides for a minimum of one year’s living expenses (preferably several years). It includes money that will be needed for upcoming purchases such as a car or a down payment on a house. Until this bucket is filled up, a client should not be investing in buckets 3 or 4. There should be sufficient money in bucket 1 that one feels secure no matter what happens to the money in investment buckets 2 to 4. This helps minimize the role of emotions in making investment decisions.
The traditional safe money bucket would be cash. When interest rates were higher, money in this category could be placed in CDs or money market funds to achieve an annual 5%-6 % return. During periods of lower interest rates, CD and money market yields may not keep pace with inflation. As a consequence, some money in this category is invested in bonds to achieve a higher return.
We prefer to buy individual bonds (corporate or government) and holding them to maturity, as opposed to buying a bond mutual fund. It limits our exposure to interest rate risk. Depending upon a client’s situation and tax bracket, municipal bonds may be appropriate in some cases.
Bucket 2- Stock Market Index Bucket
At least some long term/retirement investments should go into stock index funds/ETFs. For example, one could allocate money in a 401 (k) or IRA plan to an S&P 500 index fund. Although we believe that our individual stock picks can outperform the indices over the long term (see buckets 3 and 4), we cannot be certain about this outcome. This bucket is a hedge against our own mistakes. U.S. stocks historically appreciate by 8-10% per year, when held for long periods, and this type of return is sufficient for most long-term investors. The major risk with this approach is a prolonged bear market in stocks will unavoidably produce investment losses for this type of investment.
Bucket 3- Quality Individual Stock Bucket
Buckets 3 and 4 encompass a major portion of our advisory services. We are value investors with a long-term perspective. Therefore, we buy individual stocks with the intention of holding them for a period of years. Some of these stocks will be dividend-paying stocks, so they augment the income generated in bucket 1. The criteria for the selection of these stocks will depend upon the specific needs and risk tolerances of individual clients. In general, we select stocks that meet two criteria prior to purchase. First, we prefer companies whose business is likely to profit from future trends in society in some way. Second, the stock price should be temporarily depressed relative to our estimation of the company’s value.
As with bucket 2, the major risk in buying individual stocks is that a general market downturn usually depresses the value of most stocks, regardless of the performance of a company’s business.
Bucket 4- Additional Appreciation Bucket- Options and Speculative Stocks
If investment buckets 1-3 are properly established, it is acceptable to invest some funds in smaller or more speculative stocks. These are more likely to provide outsized investment appreciation. However, these stocks usually are riskier investments than the stocks purchased in bucket 3.
Options provide an means of generating returns in excess of the market averages. In buckets 2 and 3, purchasing stocks means that we are anticipating that the stock market will go up in the medium and long term. During market corrections, these buckets will incur losses. Options provide a way to make a profit, or at least hedge losses, in a bear market. Similarly, options permit profitable trades if the general market is moving sideways for an extended period. Therefore, it is worthwhile to incorporate options trading into an overall investment strategy. We sell covered calls and puts to generate additional income. We utilize spread trades to mitigate the risks involved with investing in individual stocks.