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Years ago I came to the realization that proper money management means allocating money into "3 Buckets".
- Spending
- Saving
- Investing
As noted in my recent post Low Interest Rates Have Fanned Debt to Insane Levels it is clear many people don’t even have the Spending bucket in order!
This is my approach to the "3 Buckets" system.
Spending
This is the bucket in which we set aside money to cover expenses we expect to incur over the next 2 years.
I suggest setting aside sufficient funds to cover 2 years of expenses versus the standard 6 months or 1 year of expenses that is often recommended. I I recommend this time frame because it can take much longer than 6 month to 1 year to find alternate employment if you lose your source of income in a down market.
I know a few people in mid-level management positions who were downsized. They are still looking for employment one year after being downsized.
Saving
These are funds set aside to cover future expenses to minimize the chances of going into debt. Future expenses would be money you expect to spend over the next 3 – 5 years. This could be money to replace a vehicle, pay for a new roof, a downpayment on a house, and post-secondary education expenses. If your child will be attending a post-secondary institution within the next 2 years I would view money needed for this purpose as money that should go in the “Spending” bucket.
You should not be financing the purchase of depreciable assets. This is why this bucket should have sufficient funds to finance the purchase of depreciating assets.
Investing
This is the bucket you should strive to fill since this money will enhance your wealth. I view this money as “long-term" money. Naturally, long-term will have an entirely different meaning depending on your age.
What Belongs in Each “Bucket”?
Spending
You will need money from this bucket within 2 years, and therefore, these funds should be in liquid and safe instruments.
Saving
Investments such as equities, bonds, and real estate that will give you a reasonable return over the next 3 – 5 years go in this bucket. When you withdraw money from this bucket, it should be worth at least as much as the original value of your investment taking into consideration inflation. You can see the impact inflation on your money at the following links.
Bank of Canada's Investment Calculator
Bank of Canada's Inflation Calculator
US Consumer Price Index Inflation Calculator
Investing
Investments specifically designed for the long-term go in this bucket. These are investments that allow long-term compounding to occur. Examples include high-quality, dividend-paying equities, bonds, rental properties, and other income generating investments.
Investments which do not generate positive cash flow
Relying on investments in which success hinges entirely on the appreciation in value is fraught with risk. If you invest in companies which do not pay dividends, for example, what happens if you need to raise cash during an economic downturn? This is why I invest in financial sound companies with a proven track record of increasing dividends at least annually.
I also like rental properties but the location of the properties is critical. I do not want rental properties in small communities, communities that rely primarily on 1 or 2 major employers, remote communities, or communities located a great distance from where I reside.
I also want properties which will most likely always be in great demand. This is why we like having good quality properties close to major universities which we can rent to graduate students. Location, location, location!
Principal Residence
A principal residence comprises a sizable portion of the overall net worth of many families in North America. I, however, view a principal residence much like shares in a non-dividend paying company.
While we own our principal residence “free and clear”, any monetary gain will only come at the time of sale. This is why I do not view a principal residence as an investment. It is merely a place which provides a reasonable quality of life.
Final Thoughts
Our “3 Buckets” approach to personal finances has helped us immensely. We stay conservative with money in our Spending bucket, we protect and preserve money in our Savings bucket, and we grow our wealth with money in our Investment bucket.
Thanks for reading!
