How to Manage Your Cash Flow with the Three Bucket System
Cash flow is the lifeblood of any business or personal finance. It’s the amount of money that comes in and goes out of your accounts every month. Managing your cash flow well can help you achieve your financial goals, avoid debt, and build wealth.
But how do you manage your cash flow effectively? One popular method is the three-bucket system. This system divides your cash into three categories, each with a different purpose and risk level. By allocating your cash to these three buckets, you can balance your short-term and long-term needs and optimize your returns.
Let’s look at how the three-bucket system works and how you can implement it in your finances.
Bucket 1: Emergency Savings and Liquid Assets
The first bucket is for your emergency savings and liquid assets. This is the money you need to cover your essential living expenses for at least three months in case of an unexpected event such as a job loss, a medical emergency, or a significant repair.
This bucket should be easily accessible and secure, meaning that you can withdraw it quickly and without penalty, and it won’t lose value over time. Therefore, this bucket should be kept in a savings account, an online savings account, a money market account, or a short-term bond fund.
The interest rate on these accounts is usually low, but that’s not the main point. The main point is to have enough cash to deal with any emergency without having to dip into your other buckets or resort to debt.
To calculate how much you need in this bucket, add your essential living expenses for a year (such as rent, utilities, food, insurance, etc.) and divide by 12. This will give you your monthly average. Then multiply that by three to get your target amount for this bucket.
For example, if your essential living expenses are $36,000 per year, your monthly average is $3,000. Your target amount for this bucket is $9,000.
Bucket 2: Medium-Term Goals and Spending
The second bucket is for your medium-term goals and spending. This is the money you want to use for three to 10 years away, such as buying a house, taking a sabbatical, saving for college, or funding an expensive hobby.
This bucket should be invested in a way that balances growth and risk, meaning that you can earn a higher return than the first bucket but also face some volatility and potential loss. Therefore, this bucket should be invested in a balanced fund, an age-based fund, or an all-stock fund, depending on your risk tolerance and time horizon.
The advantage of these funds is that they are diversified across different asset classes, such as stocks, bonds, and cash. They also automatically adjust their allocation based on your age or target date, reducing the risk as you get closer to your goal.
To calculate how much you need in this bucket, estimate how much your medium-term goals will cost and when you want to achieve them. Then use a financial calculator or an online tool to figure out how much you need to save and invest each month to reach those goals.
For example, if you want to buy a house worth $300,000 in five years, and you have $50,000 saved for a down payment, you need to save another $50,000 in five years. Assuming a 6% annual return on your investments, you need to save about $700 per month in this bucket.
Bucket 3: Long-Term Savings and Investments
The third bucket is for your long-term savings and investments. This is the money that you don’t plan to touch for at least 11 years or more, such as saving for retirement or building wealth.
This bucket should be invested in a way that maximizes growth and risk, meaning that you can earn the highest return possible over the long run, but also face the most volatility and potential loss. Therefore, this bucket should be invested primarily on stocks or stock funds, which have historically outperformed other asset classes over long periods of time.
The advantage of this bucket is that it allows you to benefit from the power of compounding interest and the magic of dollar-cost averaging. By investing consistently and reinvesting your dividends and capital gains, you can grow your money exponentially over time. By buying more shares when prices are low and fewer shares when prices are high, you can lower your average cost per share and increase your returns.
To calculate how much you need in this bucket, estimate how much income you will need in retirement and how long you expect to live. Then use a financial calculator or an online tool to figure out how much you need to save and invest each month to reach that goal.
For example, if you want to retire at 65 with an annual income of $60,000, and you expect to live until 90, you need to have about $1.5 million saved by retirement. Assuming a 7% annual return on your investments and a 4% withdrawal rate, you need to save about $1,000 per month in this bucket.
How to Implement the Three Bucket System
Now that you know what the three-bucket system is and how much you need in each bucket, how do you implement it in your own finances?
The first step is to set up separate accounts for each bucket. You can use different banks, brokers, or platforms to keep your buckets separate and avoid confusion. You can also label your accounts with the name of the bucket and the goal that it serves.
The second step is to automate your savings and investments for each bucket. You can set up direct deposits, transfers, or withdrawals from your paycheck or checking account to your bucket accounts. This way, you can ensure that you are saving and investing regularly and consistently without having to think about it.
The third step is to monitor and adjust your buckets periodically. You should review your buckets at least once a year or more often if there are significant changes in your life or the market. You should check if your buckets are on track to meet your goals if your risk level is still appropriate, and if you need to rebalance your allocation or change your strategy.
The three-bucket system is a simple and effective way to manage your cash flow and achieve your financial goals. By using this system, you can have peace of mind knowing that you have enough cash for emergencies, enough growth for medium-term goals, and enough wealth for long-term goals. Try it out and see how it works for you!
Source:
(1) The Bucket Approach – Money Management | Better Investing. https://www.betterinvesting.org/learn-about-investing/investor-education/personal-finance/the-bucket-approach.
(2) Creating the 3-Bucket Cash Reserve System – Entrepreneur. https://www.entrepreneur.com/money-finance/creating-the-3-bucket-cash-reserve-system-business/306065.
(3) The 3 Buckets Strategy of Retirement Planning Explained. https://moneyguy.com/2023/01/the-3-buckets-strategy-of-retirement-planning-explained/.
(4) Three Bucket Retirement Strategy – What Is This Investing Approach?. https://www.moneycrashers.com/three-bucket-strategy-retirement/.
*Investments involve risk. Investment values will fluctuate with market conditions, and security positions, when sold, may be worth less or more than their original cost. You should always consult a financial, tax, or legal professional familiar with your unique circumstances before making any financial decisions. This material is intended for educational purposes only. Nothing in this material constitutes a solicitation for the sale or purchase of any securities. Any mentioned rates of return are historical or hypothetical in nature and are not a guarantee of future returns. Past performance does not guarantee future performance. Future returns may be lower or higher.
