Before considering any specific investments, we need to set up an overall financial strategy. How will we allocate our savings to achieve a variety of goals? I find that the financial planner’s concept of allocating different “buckets” of money to different financial goals provides a useful starting point. My version of buckets of money follows. Since everyone’s needs and attitudes towards risk differ, I do not provide a one size fits all recommendation for the percentage of money that should fall into each bucket.
Bucket 1- Safe Money Bucket
This should be the initial building block of your financial plan. Safe money provides for several years of living expenses at a minimum. 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, you should not be looking at buckets 3 or 4. I prefer having sufficient money in this bucket that I feel secure no matter what happens to the money in my investment buckets 2 to 4. This helps minimize the role of emotions in making investment decisions for the other buckets.
The traditional safe money bucket might be cash, but I think of this bucket as my income fund. Back when interest rates were reasonable, everything in this category could be placed in CDs or money market funds to meet my goal of an annual 5%-6 % return. Thanks to the Federal Reserve’s attempts to juice the economy over the last decade by lowering interest rates to zero, CD and money market yields have been driven down to the 1% level and do not even keep pace with inflation. As a consequence, I have shifted most of my money in this category to corporate bonds. Careful selection of BB and BBB rated bonds has provided annual returns in the 6% range without too much risk.
Bucket 2- Stock Market Index Bucket
This could be considered the 401(k) bucket or the John Bogle bucket. At least some of your long term/retirement investments should go into stock index funds/ETFs. For example, I currently allocate new money from my job’s retirement plan to an S&P 500 index fund. Although I believe that my individual stock picks can outperform the indices over the long term (see buckets 3 and 4), I cannot be 100% certain about it. This is my hedge against my own incompetence. U.S. stocks historically appreciate by 8-10% per year (when held for long periods1), and I can live with most of my retirement money earning that type of return.
Bucket 3- Quality Individual Stock Bucket
Buckets 3 and 4 are the real focus of this web site. I am a value investor with a long term perspective. Therefore, I buy individual stocks with the intention of holding them for a period of years. At most times, this bucket will comprise the majority of my investment capital. Some, perhaps even a majority, of these stocks will be dividend-paying stocks, so they augment the income generated in bucket 1.
One focus of this site will be defining criteria for the selection of these stocks and timing of their purchase/sale. I know that a more systematic approach would benefit my investing, and I suspect the same is true for most people. My experience suggests that the factors leading to short term market success may be opposed to those providing long term value. I anticipate future discussions on this topic.
Bucket 4- The Fun and Hedging Bucket- Options and Speculative Stocks
Once your investing house is in good order from buckets 1-3, it is acceptable to have a little fun in the stock market. The stocks in bucket 3 usually are well-established companies, so they generally are not the best candidates to become one of Peter Lynch’s ten-baggers. Smaller or more speculative stocks are more likely to provide the really big winners that could change your investing life.
In buckets 2 and 3, we are betting on the market going up. In market corrections, the most reasonable action is to ride out the storm and make up your losses during the subsequent upswing. (Selling out and moving to cash as the market declines is not a strategy that I favor for reasons to be discussed in a future post.) Options provide a way to make a profit, or at least hedge your losses, in a bear market, and they offer more flexibility than simply shorting stocks. Similarly, options permit profitable trades if the general market is moving sideways for an extended period. Therefore, it is worthwhile to incorporate options into an overall investment strategy.
1- See J. Siegel (2015), Stocks for the Long Run, 5th edition.