A Method Of Allocating Or Arranging Your Savings

The Three Bucket System

Even if you don’t have much in the way of savings or investment set aside for a rainy day, it can be helpful to have in mind a system for organizing your money for when you do. Obviously, though, the very first thing to sort out is to get some savings happening in the first place! This article concentrates on what to do with savings once you have some. Preferably, also, your money will be in tax-free schemes of some sort once you have a half-decent amount saved. Just keeping money in a bank savings account is no good for the long run. With small amounts you have little choice, but it is a fact that bank interest rates are lower than inflation, so any money stored there gradually declines in value as inflation eats away at its spending power. Therefore, move it to a high-interest easy access account or tax-free savings scheme as soon as it is feasible.

The scheme that is generally recommended by savings and investment experts is known as the “Three Buckets” savings and investment money system. The idea is that you stash your cash in up to three places, depending on your needs. You would normally start with the first bucket and once that is full, move on to the second, and  then on to the third. This can be varied depending on your circumstances (and how much risk you are willing to take with your money), but that is the general idea. The three buckets are as follows.

  • Bucket A: Your Emergency Fund: Cash you can draw on almost immediately for life’s emergencies: a broken window, the cat’s vet bill, an unexpected tax demand, and most important of all, in case you lose your job. In theory you should have at least three to six months’ worth of living expenses in this bucket. Most people, sadly, do not have anything like this much set aside. This money may be stored in a high-interest tax-free but easy access scheme of some sort, for example. At worst, it could be in a normal bank account, or preferably split between a couple of banks in case one fails. Once this bucket is full, you move on to...
  • Bucket B: Saving For Known Expenses: You might be saving for a deposit on a house, for college fees, a holiday, or for some other foreseeable large expense. Furthermore, this is money that you cannot afford to lose, so it cannot go into Bucket C, below. It has to be saved somewhere relatively safe, as with Bucket A, except that easy access is not so important: you will be able to give notice to the bank, or take the time to sell whatever relatively stable asset it is invested in (e.g., savings bonds or treasury bills, etc.). If you can afford to lose it (however unpleasant that might be) you might do better to store at least some of it in Bucket C instead, where the potential growth rate on your savings is higher, but where the risks are higher too.
  • Bucket C: Long-Term Savings: Money you won’t need for a long time, if at all. This  is money you can afford to lose, and so you invest, typically in the stock market. Now many people are afraid of the stock market, calling it ‘gambling’ or similar,  and I will address that question below. For now, just note that investments in the stock markets, over the long run only, give the best returns of any method of saving money other than investing directly in a business venture, but that, of course, is a huge gamble. The preferred method of investing in the stock market for Bucket C is emphatically not “Day Trading,” but instead, “Buy and Hold.” Make sure you learn about prudent investing if you want to minimize your risk. You might read about how to think about investing at a site like http://www.fool.com where they have tutorials to explain how to do it as safely as is feasible. If you don’t put your Bucket C money in the stock market, I am afraid you will probably make smaller returns on your savings in the long run. Indeed, you will probably lose out against inflation.

You might shift funds between Buckets C and B depending on your needs from time-to-time. Similarly you will probably need to keep Bucket A topped up.

Now: is investing in the stock market gambling? Well, yes and no. Yes, because share prices fluctuate more or less unpredictably, and crash every now and then whenever the government deregulates the banking system for long enough. And no, because first of all it is not possible to avoid gambling with your money: even if you stuff it under your mattress, you are gambling that no burglar will find it, no fire will destroy it, and no government scheme to change the currency will make it obsolete. If you put it in a bank, you are gambling that the bank won’t fail, and let’s face it, banks fail all the time. You are also gambling that the government will back up its bank guarantee schemes, but historically governments frequently default on such promises in times of crisis.

Secondly, investing in the stock market is not gambling because there is a clear long-term trend of inflation-beating gains as economic productivity continues to increase. Yes, in a given short-term period, the market can go down, sometimes quite sharply, but the historical gains have succeeded in wiping out all such dips after a few years (at worst, if you bought at the peak, just before a Great Depression sets in, then after a couple of decades). There is a clear risk, certainly, but it can be managed. And the idea here is Buy and Hold. You are not supposed to be worrying about the short-term: this is money you can afford to lose, and so to keep invested in good, solid, companies that are around for the long haul, so you can ride out any short-term problems. Only if the whole economy is going into the tank for the next 50 years or so are you likely to be in trouble here. And then it will be you and just about everybody else, most likely.

Thirdly, investing in the stock market is not gambling because you can be careful about it. You can study the markets, the economy, and individual companies and sectors, and decide based on facts whether the companies you are thinking of investing in are well-run, long-term businesses, or not. Some companies will not perform, but when investment is done carefully, enough will perform to compensate for this.

If you are still not convinced, well, that’s all right: do your own research and make up your mind: it is your money, after all, and nobody is going to look after it as well as you! You will still need a Bucket C of some sort in the long run, if you are to achieve lasting financial independence. If not the stock market, then maybe somewhere else (government bonds, perhaps, but they fluctuate too, even if they do have a government-guaranteed value on their maturity dates). To keep your risk profile lower you might need some professional advice as well, but just remember that they don't care about your money as much as you do... Good luck!