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“Bucket” Asset Allocation Strategies

As I mentioned on Monday, the asset allocation section of Can I Retire? has been reworked for the new edition. I thought it would be a good idea to offer an explanation for the change.

The prior edition presented a “buckets” method for determining how much of the portfolio to put into cash, how much in bonds, and how much in stocks. In place of that discussion, the new edition includes a discussion of various factors affecting the risk level of your portfolio (e.g., stock/bond breakdown, credit quality of your bond holdings, and duration of your bond holdings), making the case that for any given investor, rather than one perfect asset allocation, there is a whole spectrum of reasonable asset allocations.

Buckets: A Mental Accounting Method

The point of the buckets concept is simply to make it easier to decide how much money to have in each asset class — that is, to give people an intuitive way to settle on an asset allocation.

There is not, however, any economic significance to the mental partitioning of the portfolio into three separate “buckets.”  It’s akin to the way in which some people have separate savings accounts for specific goals, or the way in which some people use a cash budgeting system with separate envelopes for each part of the monthly budget (e.g, gas, groceries, entertainment). The money doesn’t care which savings account, envelope, or bucket it’s in. There’s no economic point to separating the money. But, for various reasons, it can make things mentally easier.

Unfortunately, based on reader feedback, it appears that I did not make that sufficiently clear in the first edition of the book, and a significant number of readers got the impression I was making the case that there is something inherently preferable about a bucketed portfolio to a non-bucketed portfolio.

In the end, I decided to eliminate the bucket discussion completely and replace it with something that is, I hope, more difficult to misconstrue.

Avoiding Analysis Paralysis

As we’ve discussed several times here on the blog, without the use of a crystal ball, there’s no such thing as a perfect portfolio. The best we can do as individual investors is create a portfolio that is in the right general ballpark for our personal level of risk tolerance.

Yet, almost everyday, I hear from investors who are fretting about small changes (e.g. carving out a 5% allocation to REITs at the expense of other stock holdings) or who have a portfolio that they know is a mess but that they can’t bring themselves to change until they figure out the perfect asset allocation for their new, updated portfolio.

So the goal with the rewritten section on asset allocation is to help investors avoid (or overcome) “analysis paralysis” by being as explicit as possible about the point that “good enough” really is good enough. Or, as Jack Bogle once wrote (quoting a Prussian general, apparently), “The greatest enemy of a good plan is the dream of a perfect plan.”

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If you want to discuss this article, I recommend starting a conversation over at the Bogleheads investing forum.
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