The Three Buckets: A Practical Approach to Investing for All Phases of Life

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I remember being a new investor and often wondering if I was saving my money the “right way.” I’m not sure if I even knew there was a right way or what that meant. At the time, I was unsure how to navigate the vast investment world with all of its options. It was like looking at a 15-page Cheesecake Factory menu—it was hard to pick something with complete confidence. 

I either shied away from investment decisions altogether, hoping that I was on the right track, or I’d go down the rabbit hole researching different types of accounts, mutual funds, stocks, ETFs, crypto, real estate, or the occasional and unfortunate MLM “passive income” scheme until I could no longer think straight.

Luckily, I learned how to confidently direct my dollars into various accounts and investments and feel at peace with my decisions without extensive hours of research. The key was an approach called the three buckets, which represent three different phases of life:

• Bucket Number One: Short-term (about one to two years)
• Bucket Number Two: Intermediate-term (about two to five, or possibly two to 10 years, depending on the age of the investor)
• Bucket Number Three: Long-term (about 10 or 15-plus years, depending on age)

Investing ultimately comes down to risk versus return through the question: How much risk are we willing to take on in order to get a certain level of return? 

To answer this question, we have to go a level deeper by asking: How much time do we have to invest our money in order to justify that level of risk/return? Furthermore, how much will these goals cost in future dollars, including all necessary variables such as taxes and inflation?

Life is unpredictable, so our plans need to be flexible. It’s great if we know exactly when we’re going to purchase something like real estate or a car or exactly when we’re going to retire. The truth is, most people don’t know when, if, or how those things might happen—and that’s perfectly fine. Even if we don’t know those details exactly, we can still give ourselves the opportunity to have choices now and in the future by utilizing the three-bucket concept. 

Here’s a look at each of the buckets and how they’re used.

Bucket Number One: Short-Term Money

Any funds that we’ll need access to in the next one to two years fall into bucket number one. Here, liquidity (also known as access to funds) and the safety of principal are of utmost importance. If we might need to use our money relatively soon for emergencies (having six to 12 months of living expenses saved up) or opportunities (putting a down payment on a house), we want to make sure we can access cash quickly when we need it, and that we’re not risking losing our money while we wait. 

While it would be tempting to take our cash and try to earn a higher return in something like the stock market, a short time frame of one to two years is just too short to justify the risk of a potential loss. If someone were to invest in a stock in that short of a time frame, it would be more like gambling instead of sound, risk-managed investing. We only want to invest in the market what we’re willing to lose.

Accounts like checking/savings accounts, money market funds, or even short-term CDs or U.S. Treasuries are common bucket number one investment vehicles and can be opened through banks, brokerage firms, credit unions, or other financial institutions. Even though these investments will typically earn a lower return over the long run than other investments like stocks, real estate, etc., the benefits include a lack of risk and quick access to cash. 

Bucket Number Two: Intermediate-Term Money

Bucket two is for money we don’t foresee needing in the next year or two, but it also might not be earmarked for the long term (10-to-15-plus years from now). We all have financial goals that will happen sporadically over the next few years, such as saving for college, putting a down payment on a real estate property, or starting a small business. 

Sometimes, we don’t even know what our goals are yet. That’s okay—we don’t need to have specific plans yet in order to take advantage of this bucket. In fact, that’s all the more reason why we should be building this bucket: to give ourselves options. 

Once enough funds are built up in bucket one for any short-term cash needs like bills, emergency funds, upcoming purchases, etc., we can look to make use of bucket two for our excess income or cash. That way, we’re not leaving those funds sitting around, allowing inflation to erode purchasing power as time passes.

One vehicle we can use for this bucket is a brokerage account, which allows us to participate in investments like stocks, bonds, mutual funds, ETFs, and other types of investments ranging from low to high risk. Whether we feel comfortable picking our own investments, want some free guidance in setting up our portfolio, or are willing to pay for professional management services, there are plenty of brokerage firms available to choose from, and most allow investors to open accounts online for free. 

This bucket gives investors the opportunity to participate in various markets by taking on levels of risk that are comfortable to the individual. We can adjust our investments and allocations over time and hold multiple brokerage accounts with different goals/risk levels/time frames. 

Over the long run, returns from the mix of investments available in this bucket will outperform inflation and the returns you’d get in investments held in bucket number one, but that will come at the price of some volatility along the way. The key is to manage that volatility based on when we’ll need our money. 

For example, a brokerage account that holds five to 10 individual tech stocks is going to be much more risky than an account with five to 10 diversified mutual funds or ETFs, so the tech stocks might have more potential for growth but also more potential for loss. Therefore, the tech stock portfolio might be better suited for a young investor with a longer time frame whose main goal is long-term growth because they have the time to justify that level of risk. 

However, the diversified portfolio might be better for someone trying to save money for their child’s college tuition in the next five to 10 years or for a home down payment because their main goal is growth with minimized volatility, and they don’t have 10 to 20 years to justify taking on more risk. 

In general, the longer our time frame for investing, the more risk we can usually afford to take on because there is time to outride the inevitable short-term market fluctuations.

In bucket number two, money is fairly liquid. A stock or mutual fund can easily be sold and moved to cash within a couple of business days before it’s accessible. Employee stock plans might be accessible as they vest in weeks/months/years. A real estate investment property could potentially be sold for cash fairly quickly. 

However, one key drawback of this bucket is the investments within it are usually subject to taxation in the form of capital gains and interest tax when holding and/or selling them, which eats into long-term returns over time. So, while it’s great that this money has the ability to grow and is fairly easily accessible, it might not be best to park all of our long-term savings into this bucket because of the taxation issues. 

Bucket Number Three: Long-Term Money

For any investments we’re earmarking for the long haul, Bucket number two will come into play. This is the money we’re saving for retirement, long-term healthcare needs, etc., that we foresee occurring 10-to-15-plus years from now. Because we have such a long time frame for needing this money compared to our money in buckets one and two, we can afford to take on more risk in this bucket. 

When we have the time to outride the inevitable dips in the market, we can look at longer-term, growth-oriented investments/accounts. The various accounts we can hold in this bucket include traditional/Roth IRAs, 401(k) plans, or other employer-sponsored retirement accounts. 

Within these accounts, we can hold the same types of investments that we can hold in bucket number two, like stocks, bonds, mutual funds, or ETFs. Or we can be invested in a long-term business or real estate. 

The longer our time frame, the more aggressive and growth-oriented we can afford to be (someone retiring in 30 years might be comfortable holding 100% stock, private equity, and real estate in their bucket number three, while someone retiring in five years who has built a nest egg might feel more comfortable in a 50/50 portfolio of stocks/bonds while also generating income from various buy-and-hold rental properties). 

The major benefits of this bucket include compounded growth and tax savings through IRS guidelines (refer to the IRS website for exceptions and restrictions). Investors can make pretax contributions and get tax-deferred growth along the way and/or Roth treatment, in which the tax savings come later when money is withdrawn. Most retirement accounts, like brokerage accounts, allow for automatic/recurring contributions, which makes saving in those accounts even easier. 

While these investments can be optimal for long-term growth and tax savings, the drawback is the lack of liquidity. There are certain exceptions the IRS may grant depending on the situation, but generally, the money in these types of accounts is restricted from withdrawals until age 59 1/2. This means it’s important to only put funds in these accounts that we’re comfortable not accessing until we’re at the proper age. 

Related: The Three Phases of Your Financial Life—Where Are You?

Conclusion

All three buckets have their pros and cons, and we need to utilize all of them well to create a sound, flexible financial plan. On one end of the spectrum is the liquid short-term bucket with low growth potential. On the other is the long-term bucket with poor liquidity but maximum growth potential. In the middle is the intermediate bucket, which has fairly good liquidity and growth potential but presents the issue of taxation. 

These buckets are not always, or even ever, going to have equal amounts in them. No two investors are the same, so just because someone is doing something different doesn’t mean one is right or wrong. If we can get a good grasp on our personal goals, the time frame for needing our money, and how much our goals might cost, we can answer the ultimate question of “how do we invest our money?” because we’ve looked at it from the perspective of risk management. We can, therefore, create a balance of the buckets that’s appropriate for us individually, make adjustments as we go, and maximize every hard-earned dollar for all phases of life.

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.