The bucket strategy is a commonly used investment strategy, dividing a retirement portfolio into at least two different accounts. One account is invested in a more aggressive manner for future spending needs, and the other one (or two, in some cases) contains enough cash and liquid assets, like high-quality bonds, to fund several years of retirement. The “bucket” with safer assets would be filled up only when the riskier “bucket” performs well. This is done by selling assets in the risky bucket and transferring cash to the safe bucket.
Bucketing: The Superior Strategy?
In the most comprehensive analysis yet, a recent academic study by Javier Estrada, a professor of finance at the University of Navarra in Barcelona, pours cold water on the idea that the bucket approach is superior to other retirement funding strategies.
Bucket approaches have great intuitive appeal as they deal with the well-known behavioral bias of “mental accounting” – the tendency to categorize and evaluate economic outcomes by grouping assets into a number of non-interchangeable “mental accounts.” While the bucket approach may have psychological benefits, that does not mean it is the optimal way to construct your portfolio. In fact, Estrada’s study found that the bucket method of portfolio construction underperforms static strategies (one account, rather segregating assets into different accounts) across all four main ways of assessing performance.
The Need for Rebalancing
The reason for this underperformance comes down to one crucial principle of effective portfolio management: rebalancing. While the bucket strategy does rebalance in one direction – selling riskier assets when they perform well to fill up the safe asset bucket, it does not rebalance in the other direction – buying riskier assets when they underperform. In this scenario, investors are getting only one half of the age-old investing maxim: “buy low, sell high.” Mr. Estrada sums it by saying, “however plausible, comforting, consisting with mental accounting, and easy to implement the bucket approach may be, simple static strategies, which call for periodic rebalancing and are just as easy to implement, would make retirees better off.”
One of the most important roles of a wealth advisor is to help investors overcome their personal biases, allowing them to make economically optimal decisions. While using a static strategy may be more difficult for an advisor to explain, it is clearly in their client’s best interest.
Contact a Claris advisor to learn more and see how we can help you Understand. Invest. Relax.