Building an investment bank is an important part of preparing for a comfortable retirement. But it’s also important to have cash on the side to cover living expenses without needing to sell stocks. Doing so makes it easier to ride the ups and downs of the stock market while consolidating your priorities.
A popular guide to having both is the “bucket strategy.” Read on for details on what this strategy involves and how to use it.
How the bucket strategy works
A bucket strategy usually involves having three categories: short-term, medium-term and long-term assets. Cash is a short-term asset, as it is something you will use for everyday needs like groceries and gas. Bonds can be used as medium-term assets that provide fixed interest payments. Bucket strategy bonds typically mature in three to five years.
Stocks are long-term assets in your portfolio and offer growth opportunities. Ideally, you won’t have to touch the money you invest in the stock market for at least five years.
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First bucket: Income safety net
Safety net income covers living expenses so you don’t need to quickly touch your nest egg. Every year that you can delay taking money out of your portfolio is another year that gives your money time to compound.
Financial advisors generally recommend an emergency fund with enough money to cover at least six months of living expenses. As you near retirement, you may want to withdraw that fund to cover a year or two — or even more — of living expenses.
You can put this money into a high-yield savings account so that it accumulates interest, giving your short-term savings a mile beyond what it would in a regular savings account.
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Buckets two and three: Stability meets growth
The second bucket contains investments with lower risk than the third bucket, such as bonds and equities.
The third bucket is usually made up of long-term growth stocks. Stocks tend to outperform bonds and can help keep inflation from eating into your savings. It’s easier to stay invested in stocks if you have two other short-term buckets, since you won’t be forced to sell stocks during the adjustment period to cover your living expenses. Remember that this is just a general guide, and these buckets should be made of items that make sense for your financial situation and goals.
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Keeping it balanced
The value of each bucket will change throughout the year as you spend money and commodity prices rise or fall. That’s why it’s important to review your three buckets regularly — like once a year — to make sure they’re all aligned with your goals.
Start by calculating how much you spend each year to find out how much money you need in your first bucket. Knowing this number can help you determine if you need to sell any stocks or if your income-generating assets are sufficient. If you must sell stocks, starting with an overweight position can further diversify your portfolio and reduce your overall downside if one of your stocks loses value next year.
It is also important to consider your risk tolerance and your specific financial situation. Diversifying into low-risk stocks may make sense for one retiree, while building savings may be the best move for another.
You’ll also need to consider how Social Security and interest reduce your living expenses as you rebalance your buckets. Some investors may choose to keep only enough cash to cover a year’s worth of expenses so their extra money can grow in a stock portfolio, while others may want to have more cash on hand.
