I had a beer and some pretzels with an old friend & colleague on a snowy day last week and caught up on his life and plan for financial independence and retiring early (FIRE).
He has a few years to go before his FIRE escape date, but had questions about asset allocation as he gets closer to it. His horizon is about 7-10 years, so it is a good time to be thinking about how to balance being aggressive enough to max out his retirement investments, yet start to protect his retirement bankroll against an unfortunately timed economic calamity.
I suggested a “three buckets” approach that we used to plan our investments as we reached early retirement last year. The simple strategy is to think about your portfolios as a trio of distinct buckets – each with it’s own risk profile to meet specific needs over a different time horizon.
Here’s how we established our buckets:
10 YEARS OUT – When we were about 10 years from early retirement (in my late 30s), we began taking money out of the stock market and started putting money into safer investments, such as simple bond funds. This was about the time that we started working with our financial planner and he helped us allocating part of our investments (401ks, IRAs) into a different mix. Most of our money remained in the stock market, but some was ‘protected’ against downturns like the one in 2008. The money that continued to be invested aggressively in the stock market became our ‘Bucket Three’.
5 YEARS OUT – We increased the amount of money that was ‘safe’ each year by a little bit. Fast forward 5 years (2011) and the we had a substantial amount of money now taken out of the market. We were probably at a 75/25 overall mix at this point and the amount of money we had taken out of equities equalled about 3 years of spending. It is the second ‘bucket’ of our three-bucket strategy. Since I have a substantial pension coming from MegaCorp, I am comfortable with not saving more than 3 years of spending in this bucket. The pension will make up the difference.
3 YEARS OUT – When we were just three years from early retirement we started building cash reserves – this is our ‘first bucket’ as in first line of defense. If the market goes to hell, I always want to have enough cash on hand so that we can sit on the sidelines and hopefully weather the storm. While we keep ours in a simple money market fund, any other plain vanilla asset that can be easily cashed-in would serve the same purpose.
How long a storm to plan for? We keep 3 years of spending in cash assets. I have seen advice on this range from 18-36 months, so we are probably on the more conservative side. As I told my friend this week, at a certain point, protecting your retirement nest egg becomes much more important than aggressively growing it.
There have been 47 recessions in the United States since 1790. That is about one every five years. On average, they have lasted 22 months and length. That doesn’t mean that they recovered their original value and 22 months – but that the economy was on a growth cycle again.
There is more detail on the three bucket strategy in this 2016 Retirement Planning Guide from JP Morgan. I’m not sure the history of the concept, although it seems to go back quite far. Here is also a link to a Wall Street Journal article that has more detail on it and talks about it growing in favor since the Great Recession.
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