By Jane Young, CFP, EA
The recent drop in the market has made many retirees apprehensive about investing in stock. The biggest threat to your portfolio may be your own investments decisions. The two greatest risks include an overreaction to a market correction and the failure to keep a reasonable allocation in stock. Selling stock when the market is low can be a huge risk to your long-term financial security.
You may spend another 20 to 30 years in retirement, so your portfolio needs to contain a reasonable allocation in stock to outpace inflation and support your financial goals.
A helpful concept to ease investment anxiety and avoid selling based on fear, is a bucket strategy. When you decide on the appropriate asset allocation for your situation, think in terms of placing your money in different buckets based on when money is needed. In most situations, your portfolio should be divided into three buckets - cash, fixed income, and stock. Stock includes individual stock, stock mutual funds and stock ETFs.
Investing based on when money is needed requires you to plan out expenses for the next several years. The money you plan to spend in the next five to six years is placed in cash and high-quality fixed income. With this buffer, you are less likely to worry and overact to stock market fluctuations. It also provides confidence to invest your long-term money in the stock market.
The first bucket covers cash requirements for the next 12 months. It should cover annual living expenses less income, an emergency fund of four to six months of expenses, and any major expenses anticipated in the next year. This should be held in cash or cash equivalents.
The second bucket should cover living expenses for at least five additional years, depending on your situation. This bucket will be used to replenish your first bucket and support your spending needs when the market is down. Money in this bucket should be invested in CDs and high-quality bonds.
The third bucket is your growth engine. This is for long-term money that is not needed for at least six years. This bucket should contain a diversified mix of stock investments.
Depending on your portfolio, risk tolerance, and income needs, you may want to keep more than five years of expenses in bucket two. It is common for those with a large portfolio to keep more than five years of expenses in fixed income. In retirement the typical allocation is 40% in bucket one and two and 60% in bucket three.Periodic rebalancing of your portfolio, usually annually, is essential for the bucket strategy to work properly. When the market is high, sell stock and replenish your cash and fixed income buckets. When the market is down, draw upon bucket one and two to cover your expenses. If you have excess in your cash and fixed income buckets, consider buying additional stock at a discount.