The Perfect Pair: Using Risk Tolerance and the Bucket Strategy to Manage Risk

A key component of any investment strategy is knowing your risk tolerance level and periodically revisiting it to ensure that investment strategies continue to reflect an appropriate level of risk for your personal circumstances. Risk tolerance is not only a measure of how comfortable you are with market volatility and potential losses that you could incur from such volatility but also how much you can afford to lose.

Keeping your risk tolerance information current is crucial for several reasons:

1. Portfolio Alignment: Your risk tolerance helps ensure that your investment portfolio aligns with your financial goals, whether they involve growth, income, or capital preservation. It helps select investments that match your comfort level with potential gains and losses.
   
   
2. Market Volatility: Over shorter time horizons, investments are more susceptible to market volatility. If you need to access your money soon, you might have to sell investments during a market downturn, potentially resulting in losses. With a longer time horizon, you have more time to ride out market fluctuations, increasing the likelihood of recovering from downturns.
   
   
3. Emotional Resilience: Awareness of your risk tolerance helps you manage emotions during market fluctuations. Investors with lower risk tolerance may struggle during downturns, potentially selling at a loss, while those with higher risk tolerance may be better equipped to stay the course.
   
   
4. Life Changes: Significant life events, such as retirement, a change in income, or family dynamics, can impact your risk tolerance. An updated assessment ensures your financial plan reflects these changes.

USING THE BUCKET APPROACH TO ADDRESS DIFFERENT TIME HORIZONS

As mentioned above, a key component of managing risk is your time horizon. While one client may have a higher risk tolerance than another client, it does not automatically mean they should have a riskier portfolio. A riskier portfolio tends to mean increased market volatility and while volatility can be positive over longer time horizons, it can be a significant risk for assets earmarked for shorter time horizons.

The bucket approach can work in direct harmony with risk tolerance for managing risk. By segmenting assets into short-term, intermediate, and long-term buckets, you can better align your investment strategies with the time horizon for those specific assets. As a general rule and starting point your short-term bucket should be viewed for assets needed under 3 years, the intermediate bucket for assets between 4 – 10 years, and finally the long-term bucket for assets earmarked for more than 10 years. Keep in mind that the timeframes provided are guidelines as each bucket’s timeframe can vary based on personal circumstance and market conditions.

For example, using more conservative assets such as money markets, treasuries, and short-term bonds for short-term assets will minimize the potential of selling investments during market downturns leading to potential losses. On the other hand, for assets in your long-term bucket that you know you do not need for more than 10 years, you can use riskier assets such as growth-oriented mutual funds, ETFs, and stocks. The longer your time horizon, the more aggressive you can be because you have time to recover from market downturns without selling these assets.

Of course, you still have to consider the emotional aspect of your risk tolerance level when choosing your investment allocation. While the bucket approach can help clients understand how they can accept more volatility (risk) for those assets earmarked for long-term goals like retirement, they still have to be comfortable with the potential fluctuations in their portfolio to avoid selling at the wrong time.
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The wonderful thing about the bucket approach is its adaptability and application for investors of all risk levels. For those that have a more conservative risk tolerance, it can help them better understand and accept appropriate risk levels for longer-term assets. This can improve the likelihood of them achieving higher growth rates that are needed to reach retirement goals. On the other hand, the bucket approach can help more aggressive investors with a higher risk tolerance avoid taking losses during market downturns by having shorter-term assets available if needed.

USING THE BUCKET STRATEGY AS A RISK MITIGATION TOOL IN RETIREMENT

The Bucket strategy can be particularly useful at retirement when you are entering the distribution phase of your investment life. One of the greatest risks to ensuring that you live a comfortable retirement and do not run out of money is sequence of return risk. This is the risk that in the early years of retirement, you experience negative performance while simultaneously drawing down on your invested assets. This can be a double whammy for retirees because they are forced to sell more shares due to lower prices, and then they no longer own those shares when the market recoups those losses or even goes higher, eroding their retirement nest egg much faster than expected. An effective way to reduce this risk is by deploying a bucket strategy with sufficient cash or short-term investments available to cover those income needs and avoiding selling during market corrections or prolonged downturns.

HOW TO CALCULATE THE AMOUNT IN YOUR SHORT-TERM CASH BUCKET

As a general guide, you should consider having cash or short-term investments available to cover any income gap or larger purchases you expect to make in the next 1 to 3 years. To show this, let us use a simple example assuming you had $55,000 in social security income between you and your spouse, and your annual budget is $65,000. You have a $10,000 gap that has to come out of your retirement assets to cover your budget each year. In addition, you plan on spending $5,000 a year on vacations, and know you need to buy a new car in the next year or two that you estimate will cost about $35,000. 

All together your short-term bucket should have $30,000 ($10,000 * 3) for your budget gap, another $15,000 ($5,000 * 3) for vacations, and $35,000 earmarked to purchase that new car. Altogether you should have $80,000 in short-term investments to cover these costs for three years while leaving longer term investments untouched. For inflation purposes or those unexpected costs, you could add a 10% or 15% cushion to your final calculation.

The bucket strategy as outlined above does not necessarily require separate accounts; rather, it can be implemented within your overall portfolio allocation. This means that while you earmark a portion of your investments for short-term needs, those funds can still be part of your broader investment strategy, ensuring liquidity without disrupting long-term growth objectives.

Combining the bucket strategy with a clear understanding of your risk tolerance is an effective way of managing investment risk, especially as you approach and navigate retirement. Regularly reassessing your risk tolerance level will help guide your approach to life changes and market conditions.

​Please feel free to Contact Us to schedule a financial review to ensure your risk tolerance aligns with your current goals and circumstances. Your StraightLine team is here to help!

​Author

Rob Rickey, CFP®
​StraightLine's Chief Growth Officer and Financial Advisor

PROFESSIONAL DESIGNATION:
Certified Financial Planner Board of Standards Center for Financial Planning, Inc. owns and licenses the certification marks CFP®, CERTIFIED FINANCIAL PLANNER™, and CFP® (with plaque design) in the United States to Certified Financial Planner Board of Standards, Inc., which authorizes individuals who successfully complete the organization’s initial and ongoing certification requirements to use the certification marks.  Those certification requirements include education, exam, experience and ethics components--more information is available at Professional Designations. 
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​DISCLOSURE:
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