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Let's start with a review of what the three-bucket approach is (from Todd's article):
"Bucket A is an emergency fund, which is cash set aside in a money market account or similar safe, instantly accessible place for... well, for an emergency (you lose your job, your septic tank explodes, statisticians hurl grapefruit through your front window, etc.).
"Bucket B represents savings that you will need within the next three to five years for extraordinary, but foreseeable, expenses. For example, saving for a down payment on a home, kids going to college, your next car, that mountain chalet, etc.
"Bucket C is long-term savings (money you won't need for at least three years, preferably much longer). Historically, the best place to put money long-term has been the U.S. stock market. You don't have to put all your Bucket C money in the market, but not doing so is likely to cost you money down the road."
As you can see, the three-bucket approach is a good dose of sound, conservative investment advice -- but I think that if you plan carefully you can keep more of your money in the market and possibly reap higher rewards as long as you understand and plan for the additional risk.
I believe that Bucket A is a must for almost all investors. The only investors who don't really need Bucket A are those with a high degree of liquid assets. If you're one of those, then you can survive most emergencies quite nicely even if you have to sell some stock at a loss. Of course, if you're that well off, why would you not want to have an emergency fund?
Bucket B is much more debatable in my opinion. I believe that my net worth would be much less today if I followed the Bucket B rationale too literally. For example, when I graduated from college one of my first goals was to save money so that in three to five years I would have enough to pay for a down payment for a house. I met that goal only because I decided to invest my money in the market, despite the fact that I got hit by the crash of '87 right in the middle. I still met my goal of buying a house earlier than I would have otherwise because I didn't follow the Bucket B rule.
Does this mean I think Bucket B should be ignored? No, because in many cases it is necessary. For example, let's say I had already saved enough money for that house. Let's also suppose that I was getting married and planning a family right away so it was very important that I buy a house in the next three years. In this example, I would not invest the money because the consequences of losing the money are too great. Even with the odds in your favor, one might not want to risk having to put off providing a home for one's family.
As another example, let's say that I had saved enough money to pay for my kid's college that he would be starting in three years. Should I invest that money in the market? Not if it's important to me that I pay for college. I should be willing to sacrifice the potential return on that money so that I am assured that I will be able to meet my obligation. Explaining that Johnny will need to spend another couple of years flipping burgers before he can follow his friends to State U. isn't something most parents want to face. And it won't do Johnny's opinion of investing any good either.
There are two major differences between the two house examples: money and importance. In the first example, the person was trying to obtain the money, while in the other the money was already obtained. This is a very important difference and one that should be considered when making investment allocations.
The other difference is that in the first example, buying a house in three years was an abstract goal. If it had taken five years instead of three it would have been no big deal. The goal was real while the consequences of missing the goal were small. Meanwhile, in the second example, the consequences were greater, therefore meeting the goal was much more important.
I personally would modify the Bucket B rule as follows:
Bucket B should represent money that you can't afford to lose in the next three to five years.
Even the most widely accepted and Foolish financial rules can be tailored to meet individual situations and needs.
Until next time, Fool on!