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By Jason Stipp and Christine Benz | 06-12-2014 01:00 PM

5 Misconceptions About the Bucket Approach

This sensible strategy can work well for investors--provided it's applied correctly.

Jason Stipp: I'm Jason Stipp for Morningstar. Many regular Morningstar.com readers are familiar with the bucket approach to retirement investing espoused by Christine Benz, our director of personal finance, but there still may be some misconceptions about this process. She's here to clear those up today.

Christine, thanks for joining me.

Christine Benz: Great to be here, Jason.

Stipp: You've written a lot about this bucket approach to retirement investing. Before we get into some of the misconceptions about it, can you just summarize, what is the bucket approach?

Benz: Whenever we talk about bucketing, I like to be sure to attribute the whole concept to Harold Evensky, the great financial planner, who has talked about using this bucket strategy as a way of calming his clients' nerves. The basic idea is that he carves out a portion of their portfolios in true cash instruments. If they know they have their near-term income needs covered, they can tolerate a lot more fluctuations and volatility in the longer-term portion of their portfolios, the net growth portions of their portfolios.

Stipp: It's a very intuitive way to think about the needs that you'd have for your portfolio over different time periods, so you can make better decisions about your investments within those buckets.

But there are, perhaps, a few misconceptions that people might have about how this bucket approach works. You say the first one is the misconception that these buckets are spent sequentially. The misconception is, you spend all of bucket number one and then you move to number two and spend all of two, and move to three. But that's not actually how it should work.

Benz: Exactly. I think people look at these buckets and think, that's what I'm doing. I am just going to spend this money down. If you use that strategy, the problem would be at the end, in your later retirement years, you'd end up with a lot of stocks in your portfolio and very little in more liquid assets. So that's really not the way that investors should go about this.

Instead what you're spending is bucket one, and then you're periodically replenishing bucket one, using a variety of different methods. Some people like to use distributions from dividend-paying stocks and income-producing bonds to refill bucket one. Another way, and the way that Harold Evensky talks about using the bucket strategy, is using rebalancing proceeds to refill bucket one--trim whatever has gone up the most in your portfolio and add those proceeds to bucket one.

But the basic idea is that you are not spending two and three as you go along; you are spending what's in bucket one.

Stipp: You will always have a bucket one, because that's your short-term bucket that you need for your immediate needs.

The second misconception is that you must have three buckets: short, intermediate, and long.

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