Over the years, it has never ceased to amaze me how unorganized people are about their money, and scope of their personal finances. On the one hand, it is not brain surgery, at the same time it does take a modicum of planning, judgment, and hard work to get it right. That also does not mean that it is going to be right every time. Mistakes are to be learned from, not to be made repeatedly. And, oh, by the way, having a bit of luck and timing occasionally does not hurt, either. I have often commented over the years that people who collect money as if they collect Hummel’s (you know, those little figurines) may look nice, but there is no sense as to why they may have been purchased. We would like to take you out of this mindset by actually giving a sense of organization and purpose to your money.
Emotion, as we have discussed, can play a negative role in investing and planning. By having your money organized in three distinct ways or “buckets,” it can eliminate much of the emotion, and at the same time, eliminate many of the improper decisions, which, are made by the use of emotion.
The bucket method (for lack of a better phrase) consists of three distinct time frames to consider. The first would be for needs and emergencies for less than one year. The second would be for needs of between one and five years, and the last would be for needs or longer than five years.
The initial bucket,
which has a time frame or objective of less than one year, should be cash or cash equivalent items. The purpose of this money should be liquidity ONLY, and the object is not to derive the highest amount of interest. The object it to make sure that the principle is safe and the money is readily available. Examples of this may be an emergency fund, tuition that is due within the next 12 months, a forthcoming celebration that has not been paid for. The rule is…the shorter the time frame, the less risk a consumer can, or should, take. If you want to waste your time in attempting to generate an extra .50 in interest combing the markets, well, knock yourself out. Frankly, in the overall scheme, it is a waste of time. Find a local bank, which offers a reasonable savings or money market account, preferably with check writing so that access is instantaneous. Spend the majority of your time on planning which is going to allow your money to grow in the longer term.
The second bucket,
which encompasses a five-year time frame, would garner a bit more risk and hopefully a bit more return. Examples of investments, which would encompass this portfolio, might be a Certificate of Deposit, one that has a time frame of no more than 12-18 months to take advantage of changing interest rate environment. If rates are on an upswing, I would consider a lesser time frame. If rate were coming down, I might consider a longer time frame. Other examples would be intermediate term bond funds, definition which have duration of up to seven years. Keep in mind there would be principle risk with a bond fund. A corporate bond fund, for example, even in today’s (2010) low interest rate environment generally has a higher yield. An equity or stock component of this bucket might be either a balanced fund, which typically would be divided between stocks and bonds. The stock component of this portfolio would be comprised of large, well-known companies, many of which would pay dividends. The object of this bucket would to allow the five-year time frame to help “smooth out” any of the short-term volatility, and to help provide a steady stream of income (first objective) and growth (second objective) to the portfolio. Keep in mind that certificates of deposit are insured and offer a fixed rate of return, whereas both principal and yield of investment securities will fluctuate with changes on market conditions.
The third and last bucket,
would have a time frame of greater than five years, and the composition of the assets within would be based upon, among other things, a consumer’s amount of risk tolerance and the suitable nature of the investment. It may encompass a broad stock, mutual fund, and ETF portfolio, or investment real estate. For the sake of this discussion, let’s consider a moderate mutual fund portfolio, which consists of one third each in domestic equities, international equities and bonds. In the very short run, this portfolio may over or under perform historical norms. As we have said in previous posts, the key to investing is time, and not timing. All “qualified” accounts, meaning Roth or traditional IRA’s, 401(k), SEP’s, 403 (b), should be included in this bucket. Even if you are retired, there is probably a need to have money invested for longer than five years, and you need to consider what amount of diversification would be appropriate for you. Any short-term need could be met by selling that portion of the account and maintaining the asset in a money market fund, which is perfectly suitable for short-term needs. By doing so, much of the guesswork is removed, decisions are made precisely and without emotion, and short and long-term needs are well balanced.
Investment decisions should be based on an individual’s goals, time horizon, and tolerance for risk. As with any financial or legal matter, consult your qualified securities, tax, or legal representative before taking action.
Income from investments may fluctuate and the value of the investment may fall against the interest of the investor. Investments seeking to achieve higher rates of return generally involve a higher degree of risk of principal.
High-yielding, non-investment grade bonds are considered to have speculative elements and involve higher risk than investment grade bonds. Adverse conditions may affect the issuer’s ability to pay interest and principal on the securities.
International investing entails special risk considerations, including currency fluctuations, lower liquidity, economic and political risks, and differences in accounting methods.