Financial Boot Camp Series: Managing Your Buckets

Happy New Year, and welcome to 2020.  If we think back just twelve months, we were starting 2019 after a significant market downturn that started in the 4^th quarter of 2018.  The first few days of 2019 for equity markets were not positive either……until suddenly the tide shifted.  Although the past year had its ups and downs, the equity markets recovered all of their 2018 losses and then some.  But when the year 2019 began, no one could have really known how the year would play out, nor can we tell you today what lies ahead for 2020.  As I pen this first article in our 2020 financial boot camp article series, the equity markets have just taken a hit on the chin due to increasing tension between the U.S. and Iran.  So what is an investor to do?

What is the biggest risk an investor faces?  Is it a market decline or is it that the investor must sell an asset at the wrong time to meet a cash need?  I believe it is the latter.  The prices of investments can change drastically in a short period of time.  Prices can also remain under stress for much longer than our patience and mental health can tolerate.  Generally, however, this type of volatility is manageable within a well-developed investment strategy.  Investment strategies vary for investors in different stages of their investment lives.  In today’s article, we are going to focus on investors who are using their investment portfolios to fund or supplement their cash needs.

This strategy is simple and effective if one is disciplined enough to follow it. The first step is probably the most difficult only because many individuals do not like budgets and do not enjoy tracking annual expenses. However, understanding annual cash flow is paramount to building and maintaining an investment strategy in retirement.  We refer to this strategy as the bucket approach.

What are the investment buckets?  At the most basic level, they are:

1. Cash
2. Bonds – debt instruments that pay interest
3. Equities – the stock of publically traded companies

Please note: these buckets can quickly become more complicated because within the bond and equity universes are many choices, but for now, we will stick to the basics with a framework for helping investors manage cash flow from their portfolio. 

Regardless of your financial stage in life, you need to have some cash tucked away.  While the amount of cash can vary greatly depending upon your personal situation, the first bucket you should fill is cash.  If you are retired, the cash bucket needs to take into consideration streams of income (social security and pensions), as well as the money that you require each year from your portfolio to close the gap (hence, why it is so important to understand annual cash flow).  If this bucket is properly funded, annual market volatility should be much easier to tolerate.

There are many ways to fill your cash bucket throughout the year.  One of the easiest methods is to let all of the portfolio’s income (interest, dividends, and capital gain distributions) drop to cash.  As the year progresses, rebalancing one’s portfolio can also be used to refill the cash bucket for the coming year, as can harvesting capital losses at year-end to manage income taxes. 

The second bucket to fill is the bond bucket.  The bond portion of your portfolio serves several purposes.  The first is income. While income generation from bonds can be challenging in low interest rate environments (like we are experiencing now), if the portfolio is high quality in nature, one’s bond portfolio should provide downside protection and asset appreciation when equity markets go south. In addition, a bond portfolio can provide a real and psychological reservoir of money that can be drawn upon when the equity market is in a multi-year funk.  If you are retired, and the equity portion of your portfolio losses value, the bond bucket should be able to cover 8 to 10 years of cash needs.  This allows the investor to give the equity market plenty of time to recover before the investor is forced to sell equities to raise cash to meet living expenses.

The third bucket to fill is the equity bucket.  Some investors may want to leave this bucket empty, but I encourage you to have some allocation to an equity strategy.  A diversified portfolio that includes equities has provided long-term investors better returns than just owning cash or bonds.  Today, as we look at the very low yields that bonds and cash provide, the case for a diversified portfolio of equities as the growth engine of a portfolio still rings true. 

The New Year is a great time to review and evaluate your investment strategy.  In good equity market periods, such as 2019 turned out to be, take the opportunity to rebalance your equity holdings back to your long-term target.  Greed is just as dangerous to an equity investor as fear.