Years ago I came to the realization that in order to get ahead financially it was critical that we allocate our inflow of funds into, essentially, “3 Buckets”.
Many people will look at this list of “buckets” and think “No kidding!”. If most people are in agreement that money should be allocated to these “3 Buckets”, then why doesn’t this happen more often? In my recent post These Debt Levels are Insane! it is clear that many people don’t even have the Spending bucket in place!
This is my philosophy and approach to the “3 Buckets” system.
This is the bucket in which we set aside money to cover expenses we expect to incur over the next 2 years; any amount less than 2 years is merely a “drop in the bucket”.
Setting aside enough money to cover a year’s worth of expenses helps a little bit but could very well be insufficient. Lose your source of income in a down market and see how long it takes to find alternate employment! I know a few people who had mid-level management positions who were downsized from the bank several months before I retired. One year after having been downsized, they are still looking for employment. They are at the stage where they are willing to take a step back in their career just to re-enter the workforce.
I view this bucket as the bucket to sustain us. Essentially these are funds set aside to cover future expenses so as to minimize the chances of going into debt. When I say future expenses I am talking about money you expect to spend over the next 3 – 10 years. This could be money you will need to spend to replace a vehicle, pay for a new roof on your house, a downpayment on a house you wish to purchase, put your child through college/university (unless your child will be attending a post-secondary institution within the next 2 years in which case this money should be in the “Spending” bucket, etc.).
By the way, you should NOT be financing the purchase of depreciable assets. This is why this bucket should at least have sufficient funds to finance the purchase of depreciating assets.
As you can gather, I don’t view money in this bucket as being money that will help you get ahead financially.
This is the bucket you should strive to fill as this is the bucket that will augment your wealth; this is “long-term horizon” money. Naturally, long-term will have an entirely different meaning for a 20 year old versus a 50 year old.
Don’t Kid Yourself
While I am of the opinion that it is extremely important to set aside funds in each bucket, this is where I may differ from many on just exactly what constitutes “Spending”, “Saving”, and “Investing” money. IF you are setting aside money in each bucket but you have insufficient funds in your “Spending” bucket and a crisis hits, you may need to move money from the “Saving” and “Investing” buckets to the “Spending” bucket. In essence, merely putting money in each bucket does not mean that this money is TRULY for the intended purpose.
Why am I so rigid with this line of thinking? Because of what goes in each bucket!
What should go in each “Bucket”?
Since money from this bucket will be expended within 2 years, you need liquid and safe instruments. This money should not be invested in equities or real estate.
Investments such as equities, bonds, and real estate that will give you a reasonable return over the next 3 – 10 years go in this bucket. The money in this bucket should be worth at least as much as the original value of your investment taking into consideration inflation. If you have no clue as to the extent of the impact inflation has on your money, here are some links that will open your eyes!
Investments specifically designed for the long term go in this bucket. This would include investments that allow long-term compounding to occur. Examples include high-quality, dividend-paying equities, bonds, rental properties, and other income generating investments.
Investments which do not generate positive cash flow
In my opinion, relying on investments in which success hinges entirely on the appreciation in value is fraught with risk. If you invest in companies which do not pay dividends, for example, what happens if you need to raise cash during an economic swoon? Think back a few years ago when we experienced a financial crisis!
I much prefer investing in companies in a strong financial position and with a proven track record of increasing dividends at least annually. I also like rental properties although the location of the properties is critical. I don’t want rental properties in small communities, communities that rely primarily on 1 or 2 major employers, remote communities, or that are located at a great distance from where I reside. I also want properties which will most likely always be in great demand. This is why we like having good quality properties close to major universities which we can rent to graduate students (no undergrads thank you!). It comes down to location, location, location!
In which “bucket” would I place our Principal Residence
While a principal residence might make up a sizable portion of the overall net worth of many families in North America, I view a principal residence much like shares in a non-dividend paying company. In fact, it is even worse than non-dividend paying equities if there are any encumbrances registered on the property for which you need to make payments (NOTE: This comment is made on the presumption you do not operate a profitable business from your principal residence).
While we own our principal residence “free and clear”, any monetary gain we expect to generate will only come at the time of sale. This is why I do NOT view a principal residence as an investment but merely a place which provides a reasonable quality of life.
Our “3 Buckets” approach to personal finances has helped us understand the differences between spending, saving, and investing. We stay safe and liquid in our Spending bucket, we protect and preserve in our Savings bucket, and we compound our wealth over time in our Investment bucket.
Thanks for reading!