Long Term Investing (Risks, Buckets and Assets)

A short set of material on personal investing, focused on long-term (aka "retirement") planning and implementation.

A few years ago, I attended a meeting of my local chapter of the American Association of Individual Investors (aka AAII) where Christine Benz of Morningstar (a popular mutual fund rating organisation) presented the concept of money "buckets". It was literally a head-slap moment that completely clarified the uncertainty I had up in my head about how to categorise money going into retirement. Before I describe the concept, let's back-track a bit to your (potentially) younger age.

Young You

At 25 to 30 years old, you're probably starting to think about "putting" money away for retirement-purposes (either because your firm offers 401k matching or someone's convinced/badgered you into opening your own IRA account). If you've gotten to this point, you're probably earning enough monthly income to (a) cover your monthly expenses, (b) have at least 6-12 months of income socked away on a readily available basis for either expected or unexpected future expenses (saving for a car/home down payment, unexpected medical bills etc.).

At this point, in some sense, you're already implementing a "bucket" strategy implicitly. Your cash account (eg. checking) serves as your most immediate, readily available cash for monthly expenses. The funds you're saving away in the second category are (or at least should be) in something that makes a bit of interest but may be a "transfer" away from daily usage (eg. a savings account, a money-market account at a brokerage etc.). Finally, any funds you're planning on putting away for retirement are a new third category, definitely not something you'll access (excepting significant emergency where the penalties are justified).

Thus, we can think about these categories along two axes:

• First, how available/liquid are the funds when you expect to need them? (ie. your checking account is supremely liquid for use on a weekly/monthly basis relative to a 3-month CD where your money is locked away for, well.../3/ months!)

• Then, when are you planning to need them? (eg. a car purchase in 18 months?, home down-payment in 36 months? etc.)

As we'll see below, the when question becomes critical in determining the appropriate investment allocations.

Technically, we could consider these three categories as "buckets" already but I don't think it's worthwhile at a young age (in fact, the bucket concept was created for retirees!). Thus, for now, your 27.5 year old self should simply consider any funds you invest in an IRA/401K as a single chunk (even if spread across accounts, vendors, assets etc.) that you won't pull from for decades.

Now, an interesting thing happens once you start getting close to considering actual retirement (whenever that might be)....you've probably spent decades essentially forgetting about your retirement accounts and simply hope they've grown at least as well as the "market" (and no worse than everyone else's retirement accounts!). When you start thinking to yourself "Hmmmm...maybe I do want to retire soon? When can I?...", treating that single chunk of retirement money as single chunk is no longer appropriate.

Why not?

• You won't have any more "standard" job-income! Thus, the years (decades) of expecting $X per month direct deposited to your checking account are no more! I know this sounds rather obvious but I can say from experience that the first few months/quarters of this can be extremely unnerving.

• Thus, since you'll have to start relying on that single chunk of money you've squirreled away for decades, it's not enough to simply "invest and forget" for decades, you'll need another way of thinking about those funds. That's what the bucket model/concept can help with.

"Older You" Needs Buckets

Of the many attributes of the formal Bucket system (formal and capitalised now!) is that in some ways, it is a mirror of the way you had to categorise money in your younger years, ie. we'll still categorise money by liquidity and planning horizon but with one critical difference -> your income is going to come from your retirement funds instead of an outside source (ie. your old job(s)).

So, what's my formal definition of the Bucket system? It's a way of formally thinking about your assets in categories (aka buckets) with a set of very well defined attributes.

Bucket 1

Most similar to your younger-self, Bucket 1 represent all your most liquid funds, readily available at a moments notice for weekly/monthly living. It's from Bucket 1 that you pay your mortgage, car payment, credit-card bills, insurance etc. Due to Bank/S&L marketing decisions, this will most likely be a checking account that pays you diddly, thus you want to minimise the amount of money that you keep in this bucket! However, if money is only going out of this Bucket, where does it come from?

Bucket 2

Bucket 2 is the newest part of the retirement "mindset", it's purpose is to generate enough income on a monthly basis that you can replenish Bucket 1 as necessary. In some ways, you can consider this the replacement for your former employment, except that income thrown "off" assets in Bucket 2 become your source of monthly/annual living expenses. So what "assets" does this entail? Essentially anything that throws of income and is of reasonably low volatility (we'll read more about volatility below). Examples include (but are not limited to):

• Money market accounts
• Bond funds (part. those that aim to maximise interest while staying in reasonably high-quality bonds).
• High dividend paying stocks

Your goal here is to create as large a Bucket 2 balance as necessary to fund your planned Bucket 1 expenses. Depending on how much you've saved over the decades, Bucket 2 may represent your entire retirement savings.

However, even in the situation where Bucket 2's income just meets (or doesn't even) meet your Bucket 1 spending requirements, there's still a reason for Bucket 3...however, we'll need a small bit of esoteric history for why.

When Social Security was enacted 87 years ago, the average life expectancy in the US was a bit over 60 years. Beside the political/sociological observation that a full retirement age of 65 would only be expected to be met by half of the population born that year (and even less by those born earlier!), the more salient statistic is that if you were born in 1960, your current average life expectancy is almost 70 (and if college-educated, non-smoker etc., significantly higher than that!). For many of us, Bucket 2 won't last long enough (by throwing off income and using up principal), hence the need for Bucket 3.

Bucket 3

Bucket 3 is the closest analogue to what a new retiree previously considered their "retirement" account(s) (401K's, IRA's, Roth's, etc.). It's meant for the long-term and thus, can incur a significantly larger amount of volatility with the promise of larger return than that could be expected from the income-producing assets of Bucket 2.

What would go into Bucket 3? In short, stocks. Over almost every period over the last century, analyses have shown that a well-diversified group of high-quality growth stocks will out-perform income-producing (ie. savings/ CD / bond) assets. Thus, unless you have a reasonably short life-expectancy, or even if your Bucket 2 is not sufficient to replenish Bucket 1, you should set at least a little aside for long-term appreciation in Bucket 3. Now, here's where wisdom has changed completely over the last decade...time for another historical side-trip.

The "classic" retirement planning model of late last century (70's through the 90's) was "straightforward": invest as long and as aggressively as you can in stocks (long-term gains) while you're working and then "convert" to bonds as soon as you retire to provide you income on which to live. This model is still reasonably prevalent in many people's minds but suffers from two critical issues:

• The first was mentioned above...we're living longer! If you retired in (say) 1985 at age 65, you were born in 1920 and thus had a average life expectancy of 53 years...individuals just making it to 65 were to be congratulated! (1920 was a particular bad year to be born from a life expectancy perspective ;-()

• How do you "convert" from stocks to bonds? Your income goes from something to essentially nothing (Social Security excepted) so the classic model was simply sell your stocks and buy bonds/bond funds. However, what if you happened to retire in the summer of 1982, 2002 or even 2009? ie. years in which the S&P 500 incurred drops of more than 25%...Can you imagine investing for decades, only to have the value of your "retirement" savings drop by more than a quarter within a single year?

These two factors have caused a major rethink of financial planning professionals, specifically to start "migrating" out of stocks years earlier before you retire (not a problem) and keep stocks a bit longer after you retire (Bucket 3!). While the classic model has it's simplicity, there is no similar clear model today..the closest I know of is the Bucket model (which I argue is a meta-investing or financial management model!).

Back to Bucket 3, you might ask, how do I use Bucket 3? In some sense, you'll know...ie. once you start significantly drawing down your Bucket 2, look for good opportunities to gradually sell some Bucket 3 assets and re-invest these in Bucket 2 assets/accounts.

Aside: It's shame that the standard is to start from Bucket 1, visually, I picture Bucket 3 (or 4) at the "top" and money flowing down over years and months to Bucket 2 (and from Bucket 2 to Bucket 1)...alas, that's not how it was formulated ;-)

Bucket Summary

Finally, I suggest one critical addition to the bucket strategy if it's relevant to you: the addition of any/all real estate equity you might hold. I consider this equity as Bucket 4, it makes sense as it's (usually) less liquid than even stock investments (ie. it has similar "timing" issues of when to sell as stocks but the logistics of selling real estate are way harder than entering a Sell order on your Broker's iPhone app!).

So let's summarise the buckets:

Bucket	Purpose	Investing Time Frame	Planned Volatility	Availability
1	Immediate spending	Weeks to Months	None!	Immediate (<2 days)
2	Income generation	Months to few years	Small (+/-5%?)	Weeks
3	Asset growth	Few years to decades	Medium to large (+/- 25%)	Months
4	Real Estate	Decades	"	Years

To read more about Buckets (their definition and sample portfolios), I recommend going directly to the source:

• The Bucket Approach to Building a Retirement Portfolio

• Our Best Investment Portfolio Examples for Savers and Retirees

- Intermission -

At this point, we'll switch from how to conceptually think about retirement money (in the most general sense over your lifetime) to the actual logistics of what to invest in (and where), helping you understand a different way of thinking about "risk" as well as some insights into the current state of the financial services industry. Good time for a break.

Your Secret Advantage ➙ "Risk"

Fundamentally, the industry's definition of risk is NOT the same as yours and mine, ie. as individuals. Let's start with a short primer.

In modern finance (defined as the last 50 or so years), the general definition of risk is the degree to which the price of something (say, a stock or mutual fund) changes more "extremely" than the average of all the other similar somethings.

Simply put, if the price of an asset goes down (say 10%) when all other assets of the same type only go down 5%, the asset is considered more "risky" (by a factor of 2). From a purely statistical perspective, risk in this context can be considered simply the ratio of the standard deviation of an asset to general standard deviation of all other similar assets. For example, a stock with a standard deviation of 4 relative to a standard deviation of all similar stocks of 2 is considered to be twice as risky (this is also expressed as it having higher volatility).

This definition has become absolutely, completely ingrained in modern finance and has thus trickled down to personal finance as well. However, I completely reject the notion that this is an appropriate definition of risk for individuals!!

Alternative

Based on my early experience in Decision Analysis (yes, 30+ years ago but the concepts are evergreen), I define risk as the probability that you will (or won't) get the outcome you want at the time you want it. That sounds rather simplistic and in some ways it is. However, when we apply this to personal investing (particular vis-a-vis retirement funding) it's a fundamentally different perspective than just thinking about how volatile the price of an asset is.

Let's do a thought experiment. You're 25 years old and want to start investing your IRA/401k for your retirement in 40 years. You can pick between two assets to invest in (an asset being anything you can purchase that you hope goes up in value):

• Asset 1 is expected to return about 5% per year on a long-term average and will only change in price at most 30% per year, ie. the maximum it might go up or down in a volatile year is 30%.

• Asset 2 is expected to return about 10% per year on a long-term average but is might go up or down by 50% in any given year.

In modern finance, Asset 2 is considered significantly more "risky" than Asset 1 (and thus, will have all the various warnings and signatures required to "make sure you know what you're getting into")

However, what's critical here is to decide the following: What really is our goal? Is it to make a particular amount of money every year? eg. the mean return we should expect of the respective asset? Or something else??

I contend that our long-term savings pile should be thought of like an old-school cookie-jar; the type we used to stash money into for a rainy-day (except our rainy day is 40 years on!). Here are some "assumptions" about old-school cookie-jars (well, maybe from the Ozzie & Harriet days but stick with me...):

• The money in the cookie-jar was used on behalf of a particular purchase at some (rough) time in the future.

• The cookie jar was opaque. Thus, on any given day, whoever is managing that cookie jar will NOT be opening it just to make sure everything's still there.

• However, if someone has borrowed money from the jar, it was assumed that over some reasonable period of time, they'd replace the money, perhaps with a bit of extra for good measure.

Let's make some observations:

• The opaqueness of the jar was fundamental to it's operation...during the period that someone borrowed money from jar, no one else probably knew!

• We didn't/don't expect that the cookie-jar will be magically "growing" every time period, it might go down as borrowing occurs, it might not grow as funds are tight or it might get large as (ir)regular deposits are made!

So, what are the analogues to retirement investing from the cookie-jar analogy?

Thus, our goal is not to achieve a particular percent return in any/every given year, rather it's to ensure that 40 years later, when you look at the balance, it's not only all there but has also significantly grown in value!

Put another way: whether or not the asset goes up or down every year is almost immaterial as long as when the funds are necessary, they're available (and bigger!) Thus, the definition of risk in this context is: After 40 years, (a) Will the money that I've invested still "be there"? (b) Will it have earned a significant enough return to compensate me for locking it away relative to the other things I could have done?

Let's look at this from the context of Assets 1 and 2 from above. If we invest in Asset 2 (and don't open the cookie jar (aka your retirement account) very often to spare your heart), you'll SIGNIFICANTLY lower your risk by increasing the chances of meeting your goal relative to Asset 1 as the probability of having a significantly larger account balance is far higher with Asset 2 over the 40 year time span. Thus, the nominally "higher" risk asset from the industry perspective is actually a less risky asset for your retirement portfolio!

So what makes this possible?

• Time-frame...note the comment above re. "over the 40 year time span". It's this perspective that places the individual investor in a completely different & unique position from that of investment and/or money managers whose performance is evaluated every quarter! Unless your significant other threatens to stop using your own money management services every few years, you have a completely different time horizon than those who'd manage your money for you. Put another way, every investment/money manager can be fired due to bad performance...thus, their investing horizon is by definition shorter than ours. This distinction is the only advantage/weapon individuals can bring to the investing war-zone (and we need all the help we can get ;-).

• Statistics is fundamental to making this possible...unless you've completely messed up analysing the expected return & volatility of an asset, the statistics of long-term return vv short-term volatility will always work out in your favor.

Aside: Always Consider Who & How You are Paying

Before we discuss how to take advantage of this dichotomy through what to invest in, we need a short aside regarding the finance industry. Fundamentally, someone is ALWAYS trying to take advantage of you in personal finance & investing space. While you are officially a/the customer (not like Meta or Google), financial service provider's interests are NOT aligned with yours (I'll cover the very few exceptions below).

Take hedge funds for example, some of the richest people in the country today became so not because they invested their own money so much better than anyone else but because they convinced enough people/institutions that they could invest better than anyone else. Thus, by hovering up billions of dollars to manage and billing for services on a percentage of the money you manage, 1.5% of a billion dollars every year adds up to significant money!

Long-winded way of saying that virtually every party you deal with in the space is trying to make money from you...while the obvious take-away is minimise said payments, you first have to understand how those payments are made/structured! We'll consider these below when we discuss various types of services and investable assets.

It's critical to keep this understand this in mind as we discuss what and how to populate your buckets.

Asset(s)

I've been using the term asset (instead of stock or bond) both intentionally and rather loosely up to this point. While an asset in this context could be an individual stock or bond, the mathematics don't work for the long time horizons due to the known and unknown unknowns that affect individual companies. From unexpected legal liability, market structure changes, technology changes, critical management changes, there are too many ways for any single company to not be able to out-perform the market on a decades-long basis.

Just staying in business as a viable entity can be a challenge over a 40 year time-span, here are the firms the constituted the Dow Jones Industrial index 40 years ago: DJI August 1982. How many of these firms do you even recognise today? If you randomly invested in any one of these firms back then (when I started putting pocket-change into my 401k), what are the chances that they still exist today in anything like their current form? What are the chances that they'd still be making enough profit to justify continued out-performance of their stock price? Remember that this was almost 20 years before the introduction of behemoths like Apple, Microsoft, Amazon, Google and 35 years before Tesla!

Thus, while I've railed against modern finance's definition of risk, the converse pillar of modern finance, ie. diversification, is still absolutely fundamental.

If you can't rely upon investing in a small set of individual stocks, what are your options? You could manually manage a larger set of individual stocks. While I don't have the math at and, old-school wisdom is that you need at least 8 but preferably 15 to 20 highly diversified stocks to make up a robust portfolio. So, first you have to pick 'em...then you have to monitor them (lawsuits? crooked CEO, someone else eat-their-lunch?)...then you have to decide (at least yearly) whether or not to keep 'em.

To my mind, this approach is explicitly contradictory to the cookie-jar perspective (the essence of which is to stuff money into it and look at it as seldom as possible).

So, instead of doing it yourself, you can pay someone to manage one or many set of stocks on your behalf. Now we get into the domain of money managers, there are several choices here that I'll group into two general buckets and mention (for fun) a third, probably unusable option.

• Collective Investment Vehicles, eg. Mutual Funds, ETF's etc.
• Separately Managed Investment Accounts, eg. bespoke money managers.
• "Hedge" Funds

Collective Investment Vehicles

Invented in the 1970's, the collective investment vehicle (aka mutual fund) was a radical (nee socialist?) concept at the time. In essence, a set of stocks where purchased and held in a single account, shares of this account where then created and sold to (mostly individual) investors, the value of these mutual fund shares was directly linked to the total value of the underlying account holding the actual stocks! Any income (aka dividends) generated by the underlying stock was transferred to the investors as well.

Such a structure provides several critical advantages. First, it immediately provides far more diversification (the set of stocks is usually above 20 but could be in the 100's) from the vagaries of any single stock. Second, it also allowed low-budget investing since the mutual fund shares could be priced significantly lower than even purchasing a single share of 1 or 2 individual stocks (this was particularly true in the 70's and 80's when the difficulty and cost of individuals buying shares was non-trivial). Finally, economies of scale play strongly as mutual fund's cost structures usually do not rise linearly with the amount of assets they manage, leading to prices (aka fees) that are much more market-sensitive (but still very consistent across competitors!).

Not only did mutual funds open up investing "to the masses", they represented the basis for the transition from retirees getting paid based on their final salary (so called Defined Benefit plans) to individuals being responsible for managing their own retirement savings (Defined Contribution plans).

So, mutual funds sound great relative to managing your own portfolio, what's the catch?

• You are paying for their service (99% of mutual fund companies are for-profit entities and have made some billionaires on the backs of you and I over the years!). How much are we talking? Most mutual funds today charge you somewhere around 0.5% to 1.5% of your assets every year to manage your money. On absolute terms, this doesn't sound like much (on a $50,000 nest egg, we're talking about $250 to $750 annually). However, there are two critical factors at play here: first, this is every year, ie. whether or not they've made you money (or more accurately done at least as well as the general market) and second, the magic of compounding means that every dollar that isn't part of the compounding cycle plays a massive role in total size of your nest egg decades down the line. I won't go into the math of why this is so (a simple calculator that illustrates it) but will only say that every single penny that decide to invest should take part in said investment plan!...ie. if there's any place to be a cheap-skate, this is it!!

• "The Plethora Problem"....Since mutual funds get paid irrespective of how well they perform, the mutual fund game isn't one of returns but much more akin to industries that can't really differentiate their products physically (bottled water anyone?), ie. it's all marketing. To say there are a "plethora" of mutual funds is an understatement...the combinatorics of how many ways you can select (say 30) stocks from a universe of roughly 4000+ "real" stocks (ie, that trade on an exchange) is 3 x 10^38^. As of this writing, there are over 7,000 individual mutual funds available to purchase in the US, note that this is more than the number of actual underlying stocks! Thus, you want a mutual fund that only invests in medium-size companies whose headquarters are in the mid-west, specialises in manufacturing nuts and bolts and whose company name starts in the early part of the alphabet?....we've got a fund for that!! (well, the company name part is only a bit of a stretch, the rest is perfectly logical in today's market).

I'll address the actual decision of mutual fund selection below (preview, it's not as hard as it seems).

SMA's or Separately Managed Investment Accounts

So, why are mutual funds called "collective" investment vehicles? When you own a mutual fund, you own shares of it, from a book-keeping perspective this looks just like owning shares of a stock, ie. 20 shares of Apple vs. 20 shares of Mutual-Fund-X. The money with which you've purchased your mutual fund shares is grouped or "collected" together by the mutual fund company to purchase the underlying/actual stock shares of the fund, hence the "collective" moniker.

Separately management investment accounts are much more "as they say", ie. you have an investment account (say at a brokerage) that can you use to buy and sell stocks. However, unlike managing this process yourself, you hire (and thus, pay) someone (or a company) to manage this account specifically and separately on your behalf. You're money stays at the brokerage and is not pooled with anyone else's. Thus, instead of a statement that says you own 20 shares of Mutual-Fund-X (that might represent 32 underlying stocks that you share ownership of with 10,000's of other individuals), your statement is simply a list of stocks that your investment manager has selected on your behalf.

Advantages

When the person (or small company) is managing an account for you, you have essentially infinite customisation possible (well, at least within the bounds of that individual's recommendations, otherwise why are you paying them!). A classic example of this is an employee of a large, publicly-traded company (let's use Apple as an example). This employee may have a reasonable amount of their wealth coming due in options on Apple shares. If they invest their other savings in a mutual fund that happens to already hold a large proportion of shares in Apple, a large degree of diversification goes away (hypothetical case, the DOJ declares Apple a monopoly which cuts it stock in half, both the mutual fund and his options go down at exactly the same time). With a separately managed account, the individual could tell their manager "buy what you think is best but not any Apple as I already 'own' it in some sense". Whether it's called personalisation or customisation, this capability is inherently not possible due to the collective nature of mutual fund!

Disadvantages

You might think the fee structure for this type of management would place it out of range for normal, individual investors. However, the majority of these advisors (or companies that provide this service) charge 1% to 1.5%, not significantly more than mutual funds! So you might ask, why don't more investors go down this route? Multiple factors are at play here:

The technical ability to scale this business is a significant challenge, leaving SMA's primarily offered by individual/small group practitioners or a small number of very large brokerage firms/banks that have invested in the technical capability to offer this (picture managing 1000's of individual portfolios, each with their own specific nuances, preferences and constraints on a consistent, accurate basis).

Thus, the selection process is akin to finding and selecting a dentist, ie. word-of-mouth, small-scale advertising etc. However, unlike a dentist, if your investment manager up and retires (or dies), you have a larger problem on your hands!

"Hedge" Funds

For sake of completeness, let's also include a short description of so-called "hedge" funds. If you have many millions of liquid wealth just hanging around (and/or are just supremely greedy), you can use the highest tier of money management. "Hedge" funds are small, collective investment vehicles that are managed as if they were separate investment accounts (ie. by hand).

What sets them apart from either mutual funds or SMA's are that they can invest in essentially anything around the world (llama farms in Peru? sure...micro-loan companies in Bangladesh, why not? oodles of repackaged mortgage investments in US residential real estate with futures exposure for an extra kicker? but of course!).

The Securities and Exchange Commission has determined that such freedom may not be in the best interest of the average investor, thus, hedge funds are limited to only accepting funds from so-called "accredited investors", aka those who have enough other money that if/when the brown stuff hits the ventilator, they won't go crying to the SEC that they we're bamboozled! Thus, minimum investment amounts usually start at $500k along with a minimum net worth of $2-3M.

Why is this category interesting? Besides the fact that you hear about them often (and that they've created billionaires), the fees are not outlandish relative to other categories above. Base management fees usually range from 1.75% to 2.5%. However, also included are "sweeteners" to increase the degree to which the managers have skin-in-the-game. Usually, these sweeteners are implemented as performance fees, ie. some % of all gains by a hedge fund each year are "kept" by the investment managers based on the performance of the respective fund you're invested in.

Usually set at 20%, performance fees are the real reason high-level individuals at hedge funds can become very rich, very quickly. For example, a classic hedge fund fee structure is called "2 and 20", ie. if your investment of $1M goes to $1.1M in a year, (for a $100k or 10% gross gain), you'll first pay a 2% management fee of $22k (2% of $1.1M) and then 'give' 20% of the $100k gain back to the hedge fund, thus netting only $80K of that gain. This would leave you with $1.058M (a return of only 5.8% net of fees) while the management company pockets $42k from you! Nice gig eh?

TO DO

• Asset Allocation, ie. how do you think about a "mix" of assets in a bucket?
• What's the difference between ETF's and Mutual Funds?
• Role of Vanguard, particularly vis-a-vis TIAA-CREF.