Does “Bucket Investing” Achieve Goals or Destroy Wealth?

Many investors, and advisors, like it; but there are some experts who apparently aren’t too sure.

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Jim Lorenzen, CFP®, AIF®

Does the ‘bucket’ approach to allocating assets to life goals make sense—or does it actually destroy wealth?   Mentally, bucket investing is simply assigning money to ‘buckets’, i.e. goals.  Advisors utilizing this  approach use a variety of buckets.  Even some celebrated elite advisors have used this method.  One uses a two bucket approach:  Bucket #1 contains a five-year cash reserve and  bucket #2 is then free to invest in longer-term investments, typically stocks, stock funds or exchange-traded funds (ETFs).

Many people find the approach appealing for several reasons:

  • No need to  wrestle with sequence-of-returns risk 
  • No need to worry about liquidating assets during a  down market
  • Comfort:  It comports comfortably with the well-know behavioral bias of mental  accounting.  It’s easy to understand having a withdrawal account and a long-term investment account.

Javier Estrada, a professor of financial management at the IESE Business School in Barcelona, Spain conducted a research study, some time back, on the merits of the ‘bucket approach’ to investing for achieving long-term financial goals.  His study included highly-detailed back-testing of both Monte Carlo and  bucket strategies, back-tested over a variety of time periods and methodologies.    His study uses\d a risk-adjusted success (RAS) measurement—it’s defined as the ratio between the mean-expected value of outcomes  and the standard deviation of outcomes

Are you asleep, yet?

Basically, he’s measuring downside risk-adjusted success—measuring only downside volatility—the dispersion of only failed outcomes as opposed to simply looking at the disparity of upside to downside outcomes.  

Okay, enough of the weeds.  His extensive research shows that while the bucket approach may have psychological  benefits, it doesn’t perform so well when tested  for the highest  likelihood of success.   It failed in all performance tests to provide enough money to cover the needed  withdrawals.  Estrada found that as he extended  the number of years for withdrawals to occur, the worse the strategy became.

Reasons for the failure?  Estrada explained:  “Most implementations of the bucket approach… distribute funds from more aggressive buckets into more conservative buckets, but not the other way around.  Put differently, although bucket strategies avoid selling low by withdrawing from bucket #1 after stocks performed badly, they do not take advantage of also buying low as static strategies do with rebalancing.”

The bucket approach is popular due chiefly to a lack of knowledge.  Surrendering to the mental  accounting bias allows investors to conveniently stop worrying.  While increasing the amount of money allocated to bucket #1 might allow them to sleep better, it also increases the odds of running out of money.

Oops.  Not good.

Jim

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Interested in becoming an IFG client?  Why play phone tag?  Schedule your 15-minute introductory phone call!

Jim Lorenzen, CFP®, AIF®

Jim Lorenzen is a CERTIFIED FINANCIAL PLANNER® professional and An Accredited Investment Fiduciary® in his 21st year of private practice as Founding Principal of The Independent Financial Group, a fee-only registered investment advisor with clients located in New York, Florida, and California. He is also licensed for insurance as an independent agent under California license 0C00742.  IFG helps specializes in crafting wealth design strategies around life goals by using a proven planning process coupled with a cost-conscious objective and non-conflicted risk management philosophy.

Opinions expressed are those of the author.  The Independent Financial Group does not provide legal or tax advice and nothing contained herein should be construed as securities or investment advice, nor an opinion regarding the appropriateness of any investment to the individual reader. The general information provided should not be acted upon without obtaining specific legal, tax, and investment advice from an appropriate licensed professional.

Hidden Surrender Charges

You could be paying them without knowing it. It pays to do some math.

Jim Lorenzen, CFP®, AIF®

I don’t know anyone, certified financial planner professionals included, who is a fan of surrender charges; but, economically they are a fact of life for many products simply to make the offering available and viable for the investment or financial product provider.

For consumers, the surrender charge represents an obstacle that stands between them and having total liquidity—and the charge itself reduces the value of the product should that liquidity be required at some future date.   Sometimes, however, consumers are already paying for the liquidity they desire even if they never need or use it!

Hypothetical example:   Mary and John have $150,000 “just in case”  money set-aside in savings.  They have no particular purpose for it but they like knowing it’s there if they should need it.  They’re not making much interest, of course, probably less than 2% – but they like the liquidity.   They’ve heard about another investment that in all likelihood could help them achieve a 5% return, but it has a surrender charge—something they would like to avoid—so they’re staying with their savings account.    In effect, due to the return difference, they’re paying 3% per year for their liquidity right now.  In three years, they will have paid 9% – $13,500!   In five years the liquidity/opportunity cost will be 15% – $22,500—even without growth. 

Maybe the alternative might be a better bet—especially if other questions result in favorable  answers:  Is the tax treatment different?  How much of the money is even subject to surrender charges and how much might be liquid without surrender charges?   Does it make sense to pay 3% in opportunity cost up front for liquidity they may not even use—or does it make more sense to pay for it when it’s needed?  And how much would it even be?

It pays  to do the math and examine all alternatives.

Jim

————————————

Interested in becoming an IFG client?  Why play phone tag?  Schedule your 15-minute introductory phone call!

Jim Lorenzen, CFP®, AIF®

Jim Lorenzen is a CERTIFIED FINANCIAL PLANNER® professional and An Accredited Investment Fiduciary® in his 21st year of private practice as Founding Principal of The Independent Financial Group, a fee-only registered investment advisor with clients located in New York, Florida, and California. He is also licensed for insurance as an independent agent under California license 0C00742.  IFG helps specializes in crafting wealth design strategies around life goals by using a proven planning process coupled with a cost-conscious objective and non-conflicted risk management philosophy.

Opinions expressed are those of the author.  The Independent Financial Group does not provide legal or tax advice and nothing contained herein should be construed as securities or investment advice, nor an opinion regarding the appropriateness of any investment to the individual reader. The general information provided should not be acted upon without obtaining specific legal, tax, and investment advice from an appropriate licensed professional.