Just as significant market drops, such as the one we experienced last week, give all of us investors an opportunity to see how risk tolerant we really are, they also provide a valuable chance to see how having — or not having — a large cash reserve really feels.
That’s the central idea behind the bucket approach. As you near retirement, you put a certain number of years’ worth of expenses into a savings account so you don’t have to take money from your investment portfolio while the market is declining.
The amount is based on how much of your annual budget would need to be covered by your investment portfolio. So, first you look at how much of your budget would be covered by steady/guaranteed income sources, such as Social Security, a defined-benefit pension, or an annuity. Then you take the remaining portion of annual expenses you’re counting on your investment portfolio to cover times the number of years you’re comfortable with — typically one to three — and put that money in a cash account, such as a money market fund.
When the market is falling, you withdraw living expenses from your cash bucket. When the market is rising, you tap your investment portfolio for some of your living expenses and to replenish your cash bucket.
Some people don’t like the bucket approach, arguing that the opportunity cost is too high. When the market is doing well, they believe there’s too high a price to be paid by keeping so much money on the sidelines.
Others value the peace of mind of knowing that whenever a bear market strikes, they won’t fall victim to so-called “sequence-of-returns risk.” In other words, they won’t have to pull money from their investment portfolio when the market is falling, thereby locking in losses and hindering their portfolio’s ability to recover.
Especially if you’re retired right now or close to retirement, how has the market’s recent volatility impacted your opinion about the bucket approach?