How to use the bucket theory to plan for your goals?
14 Sep 2022 - Contact Sayan Sircar
7 mins read
This article shows you a simple set of rules for planning any financial goal: from a month to decades away via three buckets of assets.
Table of Contents
- Using buckets: the Have vs Needs Framework
- Explaining the framework
- Calculating the NEEDs column value
- Asset allocation for the goals
- Using the HvN framework
Using buckets: the Have vs Needs Framework
We will extend the concept of the bucket theory of portfolio construction to create a framework to be used in the accumulation, i.e. the pre-retirement stage when the investor has active income and is investing for future goals.
The Have vs Needs framework (HvN) is a simple tool to tell you how much money you need to invest:
- for all of your financial goals
- which asset class should you invest in next
We will now break this down in simple terms. There are two important questions that investors who are investing for their goals continuously ask:
- how much more money do I need for my goals?
- where is the next rupee of investment should go into
These questions together answer a lot more related questions:
- where should I invest a lump sum amount?
- am I investing enough for my goals?
- do I have enough for my retirement / child’s education / house purchase goals?
- how and when should I rebalance my portfolio
We will cover each and every one of these questions in detail in a future article.Recent articles:
Explaining the framework
The HvN framework needs you to make a very 4x4 simple table with three asset class buckets and for each bucket asks you to calculate three numbers: the amount you already have (the HAVE column), the amount you need to reach your goals (the NEED column) and the difference between the two (the GAP column).
The three buckets are:
- equity bucket for long term goals while beating inflation
- debt bucket to either generate income or provide stability vs the equity bucket
- cash bucket for spending for short term goals
The columns are:
- HAVE is the total market value (at today’s prices) for the assets you own. For example if you have 5 lakhs invested in equity mutual fund, and as the latest NAV, the value of these funds is 8 lakhs then the value of the HAVE column is 8
- NEED is the present value of all of the goals. We will show how to calculate this
- GAP = NEED - HAVE and is the amount you need to grow your portfolio by to consider your goals to be funded
We also have a TOTALs row to give a high-level view of the portfolio.
Calculating the NEEDs column value
We will use a simple numerical example to calculate this. Let us say that the investor has two goals:
- Car goal: 10 lakhs needed in 3 years to buy a car. The present value of this goal is 8 lakhs (assume) and the asset allocation is 100% cash
- House goal: 30 lakhs needed in 8 years to buy a house. The present value of this goal is 13 lakhs (assume) and the asset allocation is 20% equity and 80% debt
As the table shows, the investor has ₹2 lakhs, ₹5 lakhs and ₹2 lakhs in equity, debt and cash respectively. The table also shows the total amount needed to reach the funded status of both goals combined.
By funded status we mean that for each goal, there is no need of further investment. This is an important point since it means that the invested amount will grow over the time left to reach the goal value when the goal is due.
If you are using the Arthgyaan goal-based investing calculator, then it is effortless to calculate the numbers and use this framework as below:
Our new Goal-based investing tool will help you to create and manage all of your goals in one place. Click the image below to get access:
Arthgyaan creates a system for reaching your financial goals by sharing simple, actionable advice backed by research and analysis.
Asset allocation for the goals
We use the sample asset allocation defined in this post to create the asset allocation plan for the goals.
If you have not read the article before, please read that first and then come back to this post: What should be the Asset Allocation for your goals?
Using the HvN framework
Where should I invest a lump sum amount
We go from equity > debt > cash in that order because we will give most amount of time for the equity bucket to grow. In the case above a lump sum of say 3 lakhs will go towards filing the equity bucket (by 0.6 lakhs) and then the rest ₹2.4 lakhs into the debt bucket.
Removing from buckets will go in the reverse order: redeem from cash first, then debt and then equity last.
Am I investing enough for my goals monthly
Monthly investment in SIP form will go into the cash bucket since that bucket funds short term goals. In the example, the investor needs to ensure that the cash bucket is filled by increasing the cash bucket value by ₹6 lakhs in 3 years. However, the cash bucket NEED value will also grow as the goal comes closer as per the glide path of the goal.
Do I have enough for my goals
The test for making progress is watching the value of the Gap column. We have mentioned before that over time the NEED column will increase since that is the present value of the goal. For example, if there is only one goal and the rate of return is 10% with target 10 lakhs to be reached in 5 years then:
- NEED value when 3 years are left = 10/1.1^3 = 7.51 lakhs
- NEED value when 2 years are left = 10/1.1^2 = 8.26 lakhs
This means that the gap figure should be chased by the investor to ensure that it reduces with time. If it is increasing with time, either due to market fall or lower than required investments, then the plan needs to be reviewed and more investment is necessary.
Astute readers should notice that if the gap value becomes zero, then CoastFIRE is reached since at this point the return of existing assets will take you to your FIRE goal since you no longer need to invest for your goals.
How and when should I rebalance my portfolio
We have discussed the concept of rebalancing in detail here: Portfolio rebalancing during goal-based investing: why, when and how?.
There we have mentioned that rebalancing can be triggered when the proportion of one asset class vs another changes by 5%. An alternative could be that if the GAP figure in any row becomes more than 6 months of investment value, trigger a rebalance.If you liked this article, consider subscribing to new posts by email by filling the form below.
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This article shows how a young just-married couple can invest for future goals using the Arthgyaan goal-based investing tool.
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This article shows how a very typical salaried couple with one child can invest for future goals using the Arthgyaan goal-based investing tool.
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Topics you will like:Asset Allocation (17) Basics (7) Behaviour (10) Budgeting (9) Calculator (11) Case Study (3) Children (7) Choosing Investments (24) FAQ (2) FIRE (9) Gold (6) Health Insurance (4) House Purchase (13) Insurance (11) International Investing (8) Life Stages (2) Loans (10) NPS (5) NRI (4) News (5) Portfolio Construction (34) Portfolio Review (20) Retirement (26) Review (7) Risk (6) Safe Withdrawal Rate (3) Set Goals (25) Step by step (6) Tax (15)
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