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Fill Your Buckets

Ensure Liquidity in Investment Portfolios

By Lon Jefferies

September 1, 2009

Financial planners recommend having three to six months of living expenses in a liquid emergency fund to provide income in the event of a job loss or medical emergency. How should people allocate their investment portfolio after that? DALBAR, a top financial research firm, compared the investment returns of the S&P 500 to the returns achieved by the average stock fund investor from 1988 through 2007. During this period, the S&P 500’s annualized rate of return was 11.67 percent. In contrast, the average stock fund investor achieved an annualized rate of return of only 4.48 percent. What are the possible explanations for this discrepancy? Were investors betting on Betamax rather than the VHS format? Did everyone invest their entire retirement savings in 2000 right as the tech bubble was bursting? Surprisingly, evidence suggests these factors have little impact on an investor’s long-term success. According to a study first published in Financial Analysts Journal in May, 1991, stock selection accounts for only 4.6 percent of investment returns, while market timing is responsible for only 1.8 percent. Meanwhile, the proportion of assets allocated to stocks, bonds and cash was found to account for 91.5 percent of investment returns. Nurture Your Nest Egg Proper asset allocation ensures the portfolio represents the investor’s risk tolerance. If too much of the nest egg is held in stocks and the market tanks, the investor is more likely to panic and sell. In doing this, the investor buys high and sells low. A well-devised asset allocation is a great tool to help an investor manage cash flow. A common personal finance mistake is the failure to provide sufficient liquidity in investment portfolios. Without proper liquidity, the market’s direction at the time funds are withdrawn determines whether a gain or loss is recognized. Relying on stocks as a cash source during a market downturn is a bad idea. For instance, suppose an investor retired in 2008 with a 100 percent stock portfolio and had to sell equity positions to meet daily living expenses. With market values down, this investor suffered a severe financial loss. An asset allocation strategy considering when cash will be distributed can help avoid this pitfall. The Bucket Approach Picture three buckets. The first bucket should contain money that will be withdrawn from the portfolio within two years. The second bucket contains funds that will be used in three to seven years. And finally, the third bucket holds money that will not be needed during the next seven years. The money in the first bucket should be invested in liquid, cash-type investments such as money market or savings accounts. This is short-term money which should not be exposed to market fluctuations. The second bucket, holding intermediate-term money, should be invested in bonds. Although bonds fluctuate in value, they are not as volatile as stocks. However, bond returns are usually a significant improvement on cash-type investments. Constructing a bond ladder by purchasing bonds that mature each year will refill the cash bucket once a year. The long-term money in bucket three is invested in stocks. This seven-year money is the growth portion of a portfolio and will fluctuate with the market. An investor doesn’t need to worry about a down year in the market because these stocks will not be sold for at least seven years, which is plenty of time for the market to recover. In fact, it took the U.S. stock market seven years to recover from the Great Depression. Thus, an investor utilizing this strategy would have survived the worst investment climate in history without selling assets at a loss. This strategy provides a consistent source of income when it is needed. Money from the cash bucket can be used to meet living expenses, a bond will mature each year to replenish the cash bucket, and stock positions can occasionally be sold to replenish the bond portfolio. If the market has a poor year, stocks can be held for an extended period to avoid selling during a down market. This strategy will increase the probability that funds will be available to meet any planned expenses ranging from retirement, to business expenditures, to college tuition. The recent faltering economy forced many investors to sell investments at an undesirable time. Speak to your financial professional about developing an asset allocation that represents your risk tolerance and provides sufficient liquidity to prevent having to sell your nest egg at a loss. Lon Jefferies is a fee-only financial planner with Net Worth Advisory Group, based in Midvale, Utah. As a fee-only planner, he never collects commissions on the products he recommends. He is a candidate for CFP® certification and a member of the National Association of Personal Financial Advisors (NAPFA). He can be contacted at (801) 566-0740 or Learn more about Net Worth Advisory Group at
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