Bucket portfolios seem to make sense for many investors, though professional portfolio managers do not find them rational. We could say that bucket portfolios are ‘normal’ and standard portfolios are ‘rational.’ The word ‘rational’ has a very clear definition when used by investment professionals. When we say that bucket portfolios are not rational, we mean that the tools we use to create them are not the same set of tools used to create ‘rational’ portfolios.
When discussing bucket portfolios in this article, I will describe them in terms used by Oasis Wealth Planning Advisors. There may be slight differences between these terms and the descriptions of other bucket portfolios you may know.
Bucket portfolios are designed to provide spending resources during investors’ decumulation periods, usually in retirement. They are made of three buckets, arranged by time horizon – now, soon, and later – and the investment type used in each bucket – cash, bonds, and stocks.
The first bucket contains cash, such as a money market fund, sufficient for spending needs over the next 12 to 24 months. These dollars cover the ‘now’ time horizon. Since the investment vehicles in this bucket are meant for immediate needs, we call it the Liquidity Bucket.
The second bucket contains bonds, bond funds, or other fixed income investment vehicles, sufficient for spending needs during future years two through ten. These dollars cover the ‘soon’ time horizon. Since the investment vehicles in this bucket are matched dollar for dollar with the cash flow needs for specific years, we call it the Matched Bucket.
At Oasis Wealth, we seek to have cash flow needs for the next seven to ten years in place by day one of a client’s retirement. The Liquidity and Matched Buckets hold these dollars.
The third bucket contains the rest of the portfolio value in stock funds to cover spending needs eleven or more years in the future. These dollars cover the ‘later’ time horizon. Since these dollars are invested for portfolio growth and are not matched to a specific year’s cash flow needs, we call it the Growth Bucket.
At first glance, bucket portfolios look like the usual mix of cash, bonds and stocks. However, normal investors are comforted that the value of cash in the Liquidity Bucket may show no variability. The bonds and bond funds in the Matched Bucket can be designed to greatly reduce interest rate risk and credit risk (the two main risks for bond investors). The variability of the value of the stock funds in the Growth Bucket is reduced by committing to hold those funds for seven or more years, letting time reduce the variance between beginning and ending value.
Standard Portfolio Theory vs. Behavioral Portfolio Theory
Investors who use standard portfolio theory are described as rational. They assess their portfolios as a whole, caring only about their expected return and risk as measured by the standard deviation of returns. Rational investors don’t care whether any of the increases or decreases in the values of their portfolios are due to bonds, stocks or both.
You may have heard the term ‘modern portfolio theory’ or seen portfolios that were designed to earn returns like a specific benchmark (for example, 60% stocks and 40% bonds). These are ways of referring to ‘standard portfolio theory.’
Investors who use behavioral portfolio theory, however, are described as normal. Normal investors do not consider their portfolios as a whole. They divide their portfolios and frame each part into a distinct mental account by its purpose or goal. This is why we use the phrase ‘bucket portfolio’ or ‘bucket approach’ – the investor uses mental accounting to put his dollars into three distinct buckets.
Some Reasons Why Investors Like Bucket Portfolios
To understand the behavioral advantage of a bucket portfolio, consider a year like 2022 when the prices of both bonds and stocks declined. In other words, the ‘soon’ and ‘later’ buckets were both down in 2022. An investor without a ‘now’ mental account invested in cash faced two perceived painful choices if they had spending needs in 2022.
One choice was to raise cash by selling bonds or stocks at prices lower than their reference prices. The reference prices of investments can be their prices when they were bought, perhaps years ago, but it can also be their high prices a few months ago, say in January 2022.
Such selling registers as mental losses, inducing the cognitive error of hindsight and inflicting the emotional sting of regret. Hindsight would say: Why didn’t I sell my bonds and stocks at their high prices in January 2022 when it was clear as daylight that their prices were about to tumble? Regret would exclaim: How could I have been so stupid?!
The other choice was to overcome some of the hindsight and regret and sell only a little of bonds and stocks, but also spending less than we had planned. For example, we may reduce spending by depriving ourselves of traveling to see our children and grandchildren and depriving them of gifts as generous as those we gave them the year before.
The behavioral advantage of the three-bucket portfolio, especially the availability of the cash bucket, allows us to maintain our spending goals despite a drop in the market. You can spend as much from your money market fund as you planned, avoiding the sting of regret and the deprivation of spending less on yourself and your family or selling other investments at a perceived loss.
One Cost of Bucket Portfolios
But bucket portfolios also come with a cost. They usually require larger allocations to cash than portfolios based on standard portfolio theory. Rational portfolios are willing to sell some bonds and stocks at a loss because the market that requires them to sell at a loss also provides opportunities for them to sell at a gain.
Holding cash can especially feel bad when inflation creates a loss in purchasing power, as was the case in 2022.
To Bucket or Not to Bucket
So, does it make sense to bear the cost of cash in order to enjoy the behavioral benefits of bucket portfolios? The simple answer is that it depends, and one’s own goals, circumstances and biases should likely all be considered.
Financial advisors are often well-equipped to help investors talk through and evaluate these types of trade-offs. After the events of 2022, now might be a good time for such a discussion. Oasis Wealth is especially qualified to lead this discussion because our clients have used bucket portfolios for years.