While speaking to students in a personal finance class last month, I was impressed with the quality of the questions and the genuine interest these young students had regarding their personal financial well-being. The students asked many questions on different topics centered around my profession. One question that came up multiple times was, “What is your philosophy on investing?”
I shared with the students that the topic of investment philosophy surfaces with every client in our initial meetings and is revisited throughout the relationship. I spoke of the very same things I share with our clients. My investment philosophy centers on a number of factors such as risk tolerance, investment mix and experience, asset size, and goals. However, time frame is at the center of this discussion and is a critical component in determining how to invest. And for investment time frame, I call my approach the “Three Bucket Theory”. Keep in mind this is not highly scientific, so these are not fixed time frames as much as a guideline for each bucket.
Bucket one. This is designed for very short-term needs that may occur in the next year or two. This money could be set aside for a cash reserve, an upcoming car purchase, a remodel project, or some money for next year‘s college tuition. Regardless of the goal, the time frame is too short to risk the downside pressure of investing in risk assets. Bucket one should be filled with things like cash, money markets, savings accounts, and CDs. The idea here is to embrace that the time is too short to risk the principal and in effect you trade the upside potential of other asset classes for security. As such, this bucket will not produce growth but will provide peace of mind for short-term needs.
Bucket two. This is the intermediate-term bucket. This is for goals that are somewhere between two and seven years out. Because you have more time than bucket one, you can afford to take a little bit more risk with your assets. This bucket would include some of the cash related assets that are in bucket one but would also introduce bonds, stocks, and mutual funds that invest in both stocks and bonds. This intermediate time frame again could be for college in three or four or five years, a second home that you want to purchase down the road, or any other thing that is in this intermediate time frame. The idea with this bucket is you can afford to take some risk but not as much as you’ll have in bucket three.
Bucket three. This is the long-term bucket. The time frame for this bucket is approximately eight years and beyond. This is where you can take the most amount of risk with your assets because you have the longest amount of time before needing the money. Funds for a young child to be set aside for future college needs or retirement that may be 10, 15, or 20 years out will be in bucket three. While cash protects your downside risk in bucket number one, it produces no growth. Because you have a longer time frame, bucket three assets can take on more risk and provide growth potential. This bucket would include stocks, bonds, real estate, limited partnerships, and private equity, etc.
As time passes and needs arise, the funds in the buckets change. Part of my job is to come up with the original allocation of investment choices and then adjust the allocation as your life changes and needs evolve. This may mean moving from bucket three to replenish bucket two and bucket one, or freeing up some of bucket two to ensure more for bucket three. While this framework helps simplify investment decisions, you must remember that as life is not static, neither are these buckets.
If you want help with your three bucket strategy, I invite you to schedule a call with me.