March Madness is officially here and millions of people will be filling out their brackets and watching a ton of basketball. While anything can happen in the tournament, the most successful teams usually have the best offensive and defensive systems to fit their personnel. Talent is important, but a repeatable system where specific roles are assigned and well understood is what leads to great outcomes in the long run. A good financial plan should do the same thing with your money.

The bucket approach assigns specific roles to various “buckets” of your money so they fit different needs, goals, and time horizons. It is a straightforward way to think about how to allocate your savings in a way that reduces anxiety and gives you peace of mind. It creates structure now for freedom later.

This concept was first brought to the forefront by Harry Markowitz in 1952. He would later go on to win a Nobel Prize for his work and is called the father of Modern Portfolio Theory. The idea was rethought in the 1980’s and 90’s as lower interest rates forced people to reconsider traditional asset allocation strategies. In short, the idea is to assign roles to your money in order to ensure you are taking your risk in the right places. 

This approach helps insulate people from poor decision-making in times of uncertainty and market volatility. It also ensures you are being efficient when it comes to your taxes. While everyone’s situation is different, this is a framework that can help anyone. Big returns sound nice, but the risk involved in achieving them needs to be weighed thoughtfully. Rather than focusing on picking stocks for big returns in the short-term, good financial planning should be about being financially durable and independent over the long-term. This helps create real wealth: having the options to make decisions free of financial stress to create the life you want.

The bucket approach is a way to organize a household balance sheet that allows your head to hit the pillow each night knowing you are more financially resilient. The goal is to be able to match your current and future liabilities with your assets. You also won’t have to worry as much about what the market is doing to accomplish your goals.

The root of the idea is this: while asset allocation (how you invest your money) is important, asset location (where you invest your money) is equally important. What does this mean? When bucketing assets using different time frames, the types of accounts and investment strategies you should utilize will change. To continue with the basketball analogy, we’ll use a timeframe equivalent to each shot’s distance from the hoop to break this idea down more specifically:

Bucket #1: “The Lay-Up” (0-1 Years)

This bucket should be thought of as a rainy-day fund, and so taking little to no risk with the money you allocate here makes sense. This bucket should be focused on cash and cash equivalents that you can access quickly if needed. In other words, tapping into these funds should quite literally feel like a lay-up. This ensures you have options as things come up in life without worrying about tax consequences or market volatility.

• Should be considered a “life buffer”
• Differs depending on your own personal situation, but a good general rule is enough cash on hand to cover anywhere from 3-12 months of expenses
• Allows you to avoid getting caught needing to use debt excessively in an emergency and avoid selling long-term investments to fund short-term expenses
• Could also be used to fund a big purchase you may have coming up in the near future
• Examples: money market funds, savings accounts

Bucket #2: “The Mid-Range” (2-10 Years)

Once the lay-up bucket is covered, we can move a little further from the basket with a little more confidence. This bucket should not have too much cash due to the dangers of inflation over time, but the risks you are taking here should be carefully understood. Liquidity should still be a priority in case your situation changes. You should have access to these funds to remain flexible as your life evolves.

• Invested to ensure your money’s purchasing power keeps up with inflation
• Can be invested in a combination of preservation, income, and growth strategies depending on your situation
• Examples: individual or joint investment accounts, revocable trusts, health savings accounts

Bucket #3: “The Three Ball” (10+ Years)

This should be where your retirement accounts and long-term money focused on building wealth are located. It is where you can take the most risk because the first two buckets will be utilized for spending needs first. If you fund those sufficiently over time, you will not have to worry as much about market cycles. You can let your assets remain uninterrupted to participate in long-term compounding. By not interrupting that process, the results have the potential to be truly remarkable.

• Should be focused on growth-oriented strategies to build long-term wealth the younger you are
• Can be utilized for estate and legacy planning for people giving money to family or charity
• Once you build a strategy that fits your goals and personal situation you generally should not make frequent changes
• Examples: 401(k), 403(b), IRA, Roth IRA, SEP IRA

It is important to understand the risks you are taking, and where you are taking them. Are those two factors aligned? Having an account to day trade could be useful, but is that money you may need soon? What are the capital gains tax implications? Would a market sell-off keep you up at night? Are your retirement accounts invested to fit your specific time horizon and cashflow needs? What bucket should fund a major expense like a home renovation or unexpected healthcare costs? The bucket approach can help you answer those questions ahead of time and give you more confidence in your financial picture. By “getting buckets” now, you can make sure you’re not relying on heaving a half-court shot at the buzzer when it comes to your retirement.

It is important to remember that investments in securities involve risk, including the potential loss of principal invested. Past performance is no guarantee of future results. Diversification does not guarantee a profit or protect against loss in a declining financial market. Alliance also does not make any representations as to the accuracy, timeliness, suitability, completeness, or relevance of any information prepared by any unaffiliated third party mentioned in this communication and takes no responsibility. This is not intended to be individual tax advice. Please consult your tax professional. Additional disclosures can be found by visiting alliancewealthadvisors.com/legal-disclosures.