|Summary: Putting funds into different investment buckets is not a new concept in managing one’s cash flow to meet living expenses. But there are holes in the buckets strategy. These can include timing issues, holding too many defensive investments, and higher administration costs.|
|Key take-out: A good strategy is to invest across multiple asset classes through one portfolio, making it simpler, cheaper and easier to monitor returns and make changes.|
|Key beneficiaries: General investors. Category: Investment portfolio construction.|
Many Eureka Report readers were attracted to Barron’s Robert Milburn’s article entitled Asset allocation: A new approach.
No doubt this was due to a wise appreciation that asset allocation is one of the most important drivers of portfolio performance and the quality of one’s retirement. Here I will deal with whether there is something new to learn about and whether it applies to Australian investors.
The central premise of Milburn’s article was that investors might wish to separate and manage differently monies for different purposes. This approach could be described as “purpose-based” investing and ultimately drives you to put your money into different “buckets”.
This isn’t a new idea and it makes sense at a first glance, even for retirees. In its simplest version, money needed for living and contingencies over the next two to five years, for instance, could be invested in deposits, short-term annuities and short-duration bonds, while money for the next five to 25 years of retirement could be invested more heavily in shares.
Some find comfort knowing that money for bills to be paid in the next few years is entirely provisioned. Funds left in the sharemarket can gyrate all they like, and are expected after two to five years to have a much higher probability of being in the black.
Three and four bucket variations have been suggested by others, where perhaps an intermediate time frame bucket is proposed, and a fourth bucket for investing funds for a legacy to children or charity. Some have suggested this fourth bucket could more exclusively invest in more illiquid investments like private equity and hedge funds, given the ultra-long time frame. Of course, those suggesting this are often the purveyors of those investment solutions who sometimes find it hard to justify a slice in the traditional asset allocation pie.
Topping up the buckets
A key decision when implementing short-term and longer-term buckets is when to top up the short-term bucket? Should you do it continuously with investment income like dividends as received? Or once a year? Or as late as when the first bucket is empty.
The longer you wait the more chance you give your second bucket’s growth investments time to grow and recover from a downturn, but you also become more sensitive to the value of the sharemarket at the time you top up your bucket. If the market is unusually low then this might mean selling down shares, which was one of things sought to avoid.
A second problem with a bucket strategy is that it almost inevitably leads people to hold too many defensive investments in their portfolio, reducing long-term returns. Even a longer-term investment bucket needs cash and bonds to steady the ride and also to fund the buying back of oversold equities in a down year.
The third and, I think, final hole in the bucket is that it increases administration costs and complexity, requiring investors to split their money into different portfolios each administered separately and benchmarked.
The most important thing a bucket strategy does is that it might help a few nervous investors avoid bailing out of the sharemarket at the wrong time, and provide comfort that their short-term cash flow needs are met. US investment adviser Michael Kitces puts it succinctly: “We have 150 years of history that stocks recover from bear markets, yet people still sell at the bottom”.
Consolidating your buckets
My advice is to think about using buckets, but to consolidate those ideas and invest using one portfolio. This will make it simpler, cheaper and easier for you to more professionally monitor those funds.
In the following example you end up creating a reasonably traditional 60/40 equity/bond style portfolio after breaking up your money into three buckets and applying different objectives and design rules for them.
Once your portfolio is set up, annually or semi-annually rebalance (see Get ready to rebalance) to replenish your 2-10% of non-investment cash holdings, which you can draw upon to top up your investment income together to fund living.
Know that in a diversified portfolio, say like the slightly more conservative equity-bond balanced one I shared earlier built entirely out of ETFs (An all-ETFs piece to fill your portfolio), you easily have a decade’s worth of money in cash and bonds that alone could fund living expenses – even if all your growth assets stopped paying dividends and collapsed in value.
Over that time frame there has never been a negative cumulative return for equities, and I’m pretty certain you can rely on equities returning value. Despite what the All Ordinaries price index tells you, even our underperforming local sharemarket has recovered its peak value once you count reinvested dividends.
So when it comes to investment allocation, yes make a bucket list. But it’s fine to invest using just one big one.
Doug Turek is principal adviser with family wealth advisory and money management firm Professional Wealth (www.professionalwealth.com.au).