Sage Advice: Can buckets help your investments?

Peter Coltman, one of our senior financial advisers shares some 'advice behind the advice'

As I sit here in my home office, season II of the Jacinda and Dr. Ashley show is playing to the lunchtime crowd who have gathered in the lounge.

Markets are not showing the price movement (volatility) of the first Covid wave, and in fact, they are up. Portfolios are back in positive territory. Returns are at more expected levels. Volatility is easy to discuss but sometimes harder to endure.

Yes, portfolios took a sharp drop for a while but we have seen market downturns before and worked our way through those events. It will happen again; and we will continue with our strategy.

Instead of just providing reassurance after an event happens, we often place a client's wealth into 3 buckets of money, each being invested differently. It is designed, amongst other things, to shield a client from the worst impacts to their goals and needs that markets can throw. It goes something like this...

Say you require income now or have a goal that needs to be financed in the next few years. Set that funding aside and put it in cash-like deposit investments. These funds will not earn a lot but the pay-off is very little negative price fluctuation to these funds. Money here is earmarked for spending inside the next few years. We call this 'Bucket-1'.

'Bucket-2', is for expenditure a bit further down the track, say the next 2-6 years. It could be a child education fund, mortgage pay-out or an income 'top-up' for a retiree beyond the next 2 years. This gives investments at least 2 years to recover from whatever is happening in markets. This money is likely invested in part in more volatile growth assets but these tend to return more over time. Remember, it is volatility that is a core reason for the higher growth rate of shares (growth assets).

Most of Bucket-2 money however is invested in defensive or alternate assets to help protect the overall capital value but they also return less than growth assets. A pay-off between risk and return is made and its managed as a blend. This Bucket helps top-up what is consumed in Bucket-1 over time.

You have now reduced the likelihood of significant damage from a big negative event for around the next 5 years. You ride out the storms more easily and with less impact. 5 years has historically been sufficient time over the last 100 years for your portfolio to recover from a serious negative event. Recovery means your capital is back to its previous peak value including any distributions received.

The average down-turn from big negative equity market events has been around 29 months. COVID season-1 was 5 months. Given the active funds management we employ we are also cherry-picking investments within markets; recovery can often be much faster and the opportunity for better growth higher as a result.

The final part of the strategy is 'Bucket 3'. This becomes the real growth engine of your money. It is left to grow and compound in value with little regard to volatility. Market cycles, recessions, booms, wars even pandemics are accepted as 'par for the course'. At each annual review or following a period of significant over or under performance, we rebalance this portfolio to its original mix of investments. Any top-ups to Buckets 1 & 2 are also made from here.

This simple strategy reduces stress. It avoids the very high risks of market timing. Poor decision making is kept at bay. Transaction costs are minimised. Volatility changes from being a negative to a positive to your wealth. It allows you to get on with life. Ensuring your peace of mind provides me with peace of mind.