As an investor, looking at the swings in the market can be scary.
What happens if you need your money right at the time the market is crashing? You run the risk of liquidating some of your shares at a loss.
On the flip side, though, what if you sell too early and miss out on some serious bull market gains?
Trying to time the market isn't the answer for many people, but there is a way to manage your investments in a way that can reduce your portfolio's risk due to market volatility and still allow you to capture gains. It's called the bucket strategy.
What is the Bucket Strategy?
The idea behind the bucket strategy is that you divide your portfolio into different segments, based on when you need your money. Essentially, you put your money in various buckets, and you can access what you need as you need it, leaving the rest in riskier investments designed to promote growth in a portfolio.
A bucket strategy can make sense, especially if you rely on your portfolio for the bulk of your income. Plus, depending on your situation, a bucket strategy can also help protect you against longevity risk. There's a good chance you could spend 30 -- or even 40 -- years in retirement, so maintaining a portion of your portfolio in growth assets is one way to reduce the chance that you'll run out of money.
With the bucket strategy, you focus on three main time frames for your money: short, medium and long term.
Your Short Term Bucket
The short term bucket is where you keep money that you think you'll need within the next three to five years. When the stock market is approaching a high (and could potentially crash in the next couple of years), you liquidate some of your assets that have seen solid gains. You're selling high, capturing some of your gains, without selling everything in your portfolio.
You can keep the money in assets that you consider safer, including income generating assets. Some people like to keep their short term money in cash, using high yield savings or money market accounts.
In addition to cash, some investors put their short term money in low risk bonds or money market funds.
With a short term bucket, the money is liquid, you can access it without trouble, and you know it's sitting there, waiting for you to use it even during a stock market crash.
Your Medium Term Bucket
If you don't need the money for between five and eight years (or sometimes as many as 10 years), you can keep the money in your medium term bucket. These assets might include more income generating investments like dividend index funds, real estate investment trusts, higher yielding bonds and even dividend aristocrats.
These assets come with a higher risk than what you see with cash and cash-like assets, but they also create income. Additionally, they are less likely to see huge swings along with markets. Yes, they will probably lose value during a downturn, but they often don't see the same level of drama that's associated with growth assets.
As you move your money from your medium term bucket to your short term bucket (after it's begun being depleted), there's a chance that you have seen modest appreciation and benefited from some of the income generating properties of assets in this bucket.
Your Long Term Bucket
For money that you know you won't need for eight to 10 years (or longer), it can make sense to keep it in growth assets. These investments are likely to provide you with continued portfolio growth over the long run, even though they are vulnerable to bigger swings in the short term.
One of the nice things about the long term bucket is that, even though you might see big losses on paper during a market downturn, you can turn to the money in your other buckets, so you don't need to sell while prices are low.
You have a smaller chance of taking a big loss. And, as the market improves, you can capture the gains later.
Moving Money From One Bucket to Another
The bucket strategy works by pouring assets between buckets. The idea is that as you use money in your short term bucket, you'll replace it as needed by selling assets from your medium term bucket.
Later, when growth assets are performing well, you'll sell a portion of your long term bucket, capture the gains, and invest that money in assets that make up your medium term bucket.
It's a process that allows you a little more flexibility in terms of when you sell some of your assets. The result is that you have a stash of cash available for living expenses and more immediate needs, but the bulk of your portfolio continues to grow over time.
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