The original two-bucket strategy was developed by Evensky in 1985. In my opinion, it is still one of the best ways to guarantee retirement income. The two-bucket strategy was originally called the cash-flow-reserve distribution strategy. It helps retirees to weather the storms.
This is how it works:
Split your portfolio into two parts: a cash reserve and long-term investments.
Cash Reserves:
The cash reserve funds your next 5 years of cash needs. The long-term investment portfolio contains with higher risk, higher return investments.
Roughly an economic cycle, from peak to peak lasts around an average of 5 1/2 years. Your 5 year cash reserve should last long enough to get you through a bear market, correction, or recession, without risking your portfolio. Keep in mind the cash bucket is meant to complement Social Security, your pension, and any other guaranteed income you receive. Set up a monthly automated payment from your cash reserve. This way you get automatically a fixed amount every months, just like a salary.
Top-up your cash reserves before the end of the 5 year mark, if your portfolio is doing better than average.
Long-term Portfolio:
The biggest knock on the two-bucket strategy is potential for opportunity cost (i.e. not having some funds invested in the market). Research shows that opportunity cost is more than offset by avoiding the risk of having to sell assets in a down market. Investors can offset some or all of the opportunity cost of the cash reserve by increasing the equity allocation of their long-term investment portfolio. With this strategy investors seem fine with the extreme market volatility and are less emotionally stressed.
The two-bucket strategy mitigates risk and is easy to follow. If you need a retirement strategy without overcomplicating things, take this simple approach and start building your two buckets.
Sven Franssen