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