The Bucket Investing Strategy: It Can Be Good for Many Early Retirees, and the Rest of Us

Each of us, unless we're independently wealthy, needs a good retirement plan that outlines how much money we'll need to amass before we retire, how we'll get it, and how we'll withdraw from it in a way that makes it last.

One way to approach your saving and investing is to use the "bucket" investing strategy. Here's an overview that can help you determine whether you want to use it.

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What's the bucket investing strategy?

The bucket strategy is time-based, and typically involves dividing your money into three imaginary buckets. Here's how many experts set it up:

• Bucket 1: Here's where you'll keep money that you expect to need to spend within the next year or two. These funds are best kept in savings accounts, short-term certificates of deposit (CDs), money market accounts, and the like. If you expect to need $30,000 per year (on top of other income sources such as Social Security), you would park $60,000 in this bucket.
• Bucket 2: In this bucket, you'll invest money you expect to need in about two to 10 years from now. It's your medium-term money, and it shouldn't be in stocks, as the stock market can swoon at any time and stay depressed for some years. You might invest this money in longer-term CDs or bonds.
• Bucket 3: Here you'll park money you don't expect to need for the next 10 years or so. Long-term money is generally best invested in the stock market, and one of the best ways to do that is via a simple, low-fee index fund such as the Vanguard S&P 500 ETF. There are other powerful index funds to consider as well. The thinking here is that if the market takes a dive, the money in this bucket will have time to wait for a recovery.

That's how to set up a bucket strategy. It can work well for early retirees, on-time retirees, and even pre-retirees.

Once your bucket strategy is set up, it will still require your attention regularly: As time goes by in retirement, bucket 1 will get depleted and will need to be refilled with funds from bucket 2, which will in turn draw from bucket 3. You might reassess and rebalance your buckets every year.

If you're still working, you might still use this bucket strategy, but instead of taking money out of various buckets, you could just keep adding to them as needed, using any spare income. You may have noticed, by the way, that the bucket strategy is essentially a way of thinking about and enacting asset allocation.

What's so good about the bucket investing strategy?

There are many advantages of the system. For starters, it typically keeps much of your assets in stocks, which tend to grow faster over the long run than most or all alternatives. Check out the table below, offering the returns of various asset classes between 1802 and 2021, per Wharton School finance professor Jeremy Siegel:

Data source: Stocks for the Long Run, Jeremy Siegel.

Of course, 1802 was a long time ago, and the world is a bit different now. Still, the trend continues into more recent periods. For example, over the 75 years between 1946 and 2021, stocks grew at an average annual rate of 11.3%, versus 5.8% for long-term government bonds. The lesson here is that stocks outperform bonds over most long periods.

The system also removes some emotions and brainwork out of managing your money, as it specifies how you'll invest your various buckets. It can also make you more comfortable to know that you have long-term assets growing while you're funding near-term needs.

What are the downsides of the bucket investing strategy?

Of course, few strategies are perfect. For best results, if you use this strategy, you may want to keep an eye on it. If bucket 1 or 2 is getting low and the stock market has surged, that's a great time to refill from bucket 3. If the stock market is in a slump, though, you may be selling some stocks when they're down.

How should you divide your assets?

Remember that this is just one of many ways to structure your early retirement or regular retirement. An alternative might be to just have one primary retirement portfolio, divided between stocks and bonds, or whatever you think is best for you. From that, you might sell as needed to keep a spending account full of enough money to last you a year or two -- perhaps selling more when the market has surged. If you've invested in income-producing securities such as bonds or dividend-paying stocks, that income could also be used for daily living expenses.

If you do like the bucket strategy, you could tweak the buckets' timing, adjusting it more to your risk tolerance and expectations. For example, you might use bucket 3 for money that will be needed six years from now (taking on a little more risk) or 15 years from now (being more conservative).

Whatever retirement strategy you most believe in, be sure to plan well for your future. Aiming to set up multiple income streams for retirement is also a fine idea.