Q: I’m 63 and retired. … I keep two years of cash, the rest in a diversified basket of high-quality stocks. … I’m single, no debt and own two houses. Am I crazy for not owning bonds?
A: Bonds can offer important diversification benefits. That said, your strategy is working for you and there is much to recommend it.
You are using the “bucket” strategy for managing your money. Key to this approach is setting aside enough money to meet expenses for one to three years. That money is invested in safe securities, such as bank accounts and U.S. Treasury bills.
Knowing you have money to pay your bills for two years lets you take greater risk with equities in the remainder of your portfolio. You should earn a higher return on your money with equities, and your safe savings will maintain your standard of living during market squalls.
Many financial planners rightly point out that the bucket strategy is conservative over time. You can achieve essentially the same results with potentially higher returns with a well-diversified portfolio. Still, with your investments concentrated in equities, so long as you are comfortable with the wilder ride you should still earn good returns.
That said, the bucket strategy works for many people. I imagine Richard Thaler, the behavioral economist awarded the 2017 Nobel Prize in Economics early last week, would approve. Thaler’s research focuses on how we often make decisions far less rationally than standard economic models assume.
One of Thaler’s most important insights is “mental accounting.” Economists believe that a dollar is a dollar, whether it’s in my pocket or stashed away in a savings account. But most of us treat dollars in our pocket differently from dollars in savings. In a famous paper, Thaler used this example. A couple has savings of $15,000 in an account earning interest. The money is for a planned down payment in five years for a vacation home. They buy an $11,000 car financed with a three-year loan carrying a higher rate of interest than what they are earning on their savings.
To most economists this is bad money management. Tap into the savings to buy the car. They are right. What Thaler realized is setting up different mental accounts is a way of exercising self-control. It’s why many people will have an emergency savings fund, a home buying fund, a college savings plan and so on.
The bucket system is classic mental accounting. Embrace it if it works for you.
Chris Farrell is senior economics contributor, “Marketplace,” commentator, Minnesota Public Radio.