Tuesday, April 17, 2012

Creating Your Investment Bucket List

By John Wasik

(Reuters) - Got travel or mountain climbing on your bucket list? How about taking up the guitar? If you really want to live life to the fullest in your remaining days, then what you should also add to those goals is a list of your investment priorities and adjusting your risk accordingly.

This idea doesn't come from a cheesy Hollywood movie, but rather from the study of behavioral portfolio theory put forward by Nobel Prize-winner Harry Markowitz and leading behavioral economics expert and finance professor and author Meir Statman (). They theorize that if investors divide their portfolios into mental account layers measured by risk, they can counter nervous investment errors.

This is how it works: let's say you have a $1 million portfolio. You can divide it up into different-sized buckets with goals for items like college savings and retirement. For example:

* The largest bucket, or sub-account, would be for retirement. Assume that about $800,000 is in this bucket for an event that's 15 years away. Ultimately, you would like to build this to $2 million.

* Saving for college? Earmark $150,000 for a goal that's three years away, eventually totaling $180,000 when your student matriculates.

* Want to fund a bequest for your alma mater or your favorite charity? Put aside $50,000 for a goal that's 25 years away.

If all of these goals were equal - and they are not - you might leave them in one portfolio. However, you want to take much less risk with the college fund than with the bequest goal that is 25 years away.

By marking each bucket high, low or medium risk, you've identified some prospective allocations in this behavioral approach. In this case, risk is roughly equivalent to the time you have to save for each goal. The shorter the time horizon, the lower the risk you can assign to the bucket.

The short-term bucket should be invested mostly in bonds or cash equivalents in which you cannot lose principal. This is your most secure bucket and it's for goals such as saving for a down payment on a home or a car, or to set aside money for a known expenditure like property taxes. Don't expect much, if any, return on these funds. Federally-insured money-market accounts, Treasury bills and certificates of deposit are probably the safest assets.

The medium-term bucket can be for major emergency expenses such as unemployment and out-of-pocket medical expenses. I keep that money in a short-maturity bond fund. It's not principal-protected, but it pays a somewhat higher return than a money-market fund.

A medium-term bucket is also a good place for college savings. For the biggest chunk of college funds for my two daughters, for example, I have money set aside in automatically age-adjusted 529 savings plans. As they get older, the fund company shifts more money from stocks into bonds. I like this approach because the accounts are rebalanced every year, so I don't fret about market risk. All I worry about is putting enough money in to cover soaring education bills.

Your longer-term goals can be weighted more heavily toward stocks and alternative vehicles. Again, you can choose an automatic approach through a target-date maturity fund that ratchets down stock-market risk as you age, balance your own portfolio of low-cost exchange-traded funds or hire a fiduciary adviser to select passive funds for you (the most expensive route).

As you create your bucket list, don't get tripped up by things like projected or "desired" returns. Guess on the conservative side - less than 4 percent for bonds and 6 percent for stocks.

It's also important not to try to overthink your decisions. Be flexible and try different scenarios. Use allocation engines to guide you through determining a comfortable portfolio mix. For some good calculators, see websites like those of Yahoo Finance, TIAA-CREF or T. Rowe Price.

Any comprehensive financial planner who works on a fee-only basis (no commissions) will be able to fine-tune your strategy if your needs are complex. Brokers and insurance agents should be avoided.

If you do this right, you'll be able to see a range of investing possibilities that you may not see today. There is no one right way to go about this, but if it is done with care, you can avoid a leaky investing bucket.

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