The four bucket system
If full-blown goal-based financial planning sounds too complex, then a simplified system may be better for you
By Dhirendra Kumar | Apr 19, 2017
However, in order to start working towards a goal or a target, one needs to figure out what amount of money is available for us to save and for what kind of goals. If defining goals is too much work-although it should not be-then there are simpler frameworks available.
The conventional way of doing this is to divide our income into four buckets. The four buckets are based on the immediacy of the need for the money. Let's start from the long end, which is unconventional, but I'll explain later why. The first bucket is the one where you put requirements that are seven, ten, fifteen or even more years away. Depending on your age, this could be retirement, kids' education, or anything else. The important thing is the time frame of these needs. The time frames are generally so long that it may be hard to forecast the exact amount you will need. If your child is five years old right now, how much will her child's education cost 12 or 13 years from now? It's difficult to say. Depends on what kind of an education she wants, and how much pricing change. You can guess, just vaguely guess, that it will be a surprisingly high number!
The second bucket is somewhat shorter term, say up to about five years. These could be expenses that you can forecast with more certainty. You know you'd like to buy a house in five years and will need to put down an initial payment. You know that in three to four years, your car will be pretty old and you'd like to buy a new one. These needs are distinguished from the longer term ones not just by a shorter period, but also because the shorter time frame means that they are more precisely predictable in time and amount.
The third bucket is that of immediate needs and emergency funds. Unlike the conventional way of creating these buckets, I'm not creating one for your current expenditure, because that is an implicit category. Emergency funds are something that most people ignore. You will probably have a good feel for how much you will need and three to six months of family income is not a bad starting point.
The fourth bucket is an odd one out in that it consists of the statutory tax-saving investments. It's the odd one out because it can actually be subsumed in one of the first two. However, it should be thought of as a separate entity because it saves you taxes and that itself is equivalent to earning. Moreover, depending on how exactly you make your tax-saving investments, there will be a lock-in of at least three years, so the term of investment is enforced by the tax laws instead of your own choice.
Once your are clear about the various buckets into which your savings must be placed, it becomes clear as to which kind of investments go into which bucket. Given the long time horizon of the first bucket, one should invest only in equity funds. Even though equity funds can be volatile in the short term, only they provide good enough returns in the long term to beat inflation and provide substantial returns. For the shorter term bucket, one should look at hybrid or debt funds. They are less volatile, and yet have a lower tax outgo than bank deposits. For the third, immediate needs bucket, bank deposits are the obvious way to go for most people.
However, if you can put a little bit of effort into managing this then there are other, better options. Recently, a number of app-based systems for investing and redeeming money from liquid funds have been introduced which can move your funds back and forth with great ease and speed. These offer almost double the returns of savings accounts while having the potential of being much more tax-efficient.
At the end of the day, the best way to get a grip on your future finances is to put in the effort to identify specific goals and plan according to that, as I'd described last week. However, as a starter option, the simplified four-bucket system detailed above is not a bad alternative either.