• Portfolio Strategies
  • The Three Pockets Approach to Investing

    by Timothy McCarthy

    After decades of working on Wall Street, the secret to investing successfully still remains the same as I had first learned in my early years.

    Actually, it’s no secret; many investors have heard it already. The problem is that too many investors still do not practice it. Simply put, if you invest over a period of time, properly diversify across a variety of asset classes and leave the portfolio relatively stable, it will undoubtedly grow at a greater rate than by leaving it in the bank, but with much less risk than trading.

    Why is it that so many people don’t follow such a straightforward plan?

    One answer comes from listening to what people say about their investing strategy. Over the decades of helping investors of all ages across some 25 different countries, I have been amazed at how frequently I have heard the same statements in multiple languages from people at all levels of sophistication:

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    John Klein from OH posted over 2 years ago:

    How does rate of inflation affect the allocation between the 3 pockets? When inflation is higher, wouldn't you want a greater percentage in the Savings pocket? And vice versa, when rate of inflation is low you would have less in the Savings pocket and more in the Investing pocket?

    Barry Slatton from AL posted over 2 years ago:

    inflation doesn't allow for one to sit on too much cash for too long. at 3.5-4.5% per year(this includes food and energy cost) not covered by the cpi.
    you must average 8% per year overall in order to make your investments pay off.

    Ted Rosenberger from PA posted over 2 years ago:

    Superb article! Just what I needed to hear right now. I just got a large windfall from the sale of a vacation home at a huge profit. Should this money be trickled in or invested quickly? and over how long a period?

    Jim Grant from OH posted over 2 years ago:

    I highly endorse the idea of "pockets". I have used it for years. I call them "buckets". Each "pocket" needs to be monitored and managed differently.

    John, you are asking a higher level question (which is fine/good). That is, "On what basis would a person move money between "pockets". Inflation is one of several to many criteria. Examples of other criteria are changes in a person's level of risk tolerance, age, financial condition, and personal situation. My bias is to assess my allocation of funds to my "buckets" once a year. I may not change it every year, but thinking about it makes me firm up my criteria.

    Barry, your 8% sounds reasonable, but it sounds more like a "rule-of-thumb" that has been passed around, rather than based on some type of analysis or evidence. How did you come up with the 8%? Also, what did you mean by "pay off"?

    Ted, don't buy into an answer anyone gives to your question, given the little background information you provided. I'd suggest that the answer should depend on a handful of factors. Here are two:

    * What is your current allocation of your funds amongst the 3 "pockets" and how much does that vary from your target?

    * Do you judge the markets to be near a peak or a bottom now? Recent stock market peaks occurred in 2000 and 2007. A bottom occurred in March 2009. - - - Several published analyses have demonstrated that investing a lump sum at a peak can be disastrous, taking a decade to recover from.

    There have been couple articles in the AAII Journal over the last couple of years that have addressed the "Lump sum" versus "trickle in" approaches. Check them out.

    John Knox from AL posted over 2 years ago:

    I think a significant problem in today's environment is to know what is a safe investment. For example long term government bonds with a duration of 15 would lose 75% in a five per cent increase rate.

    George Pledger from CA posted over 2 years ago:

    If you have lots of money it doesn't matter much of what you do. Just don't do too many stupid things.
    However if you are on the edge and caan't see three years ahead then you definitely need a plan. Once your plan shows some real profits and you can see some progress in your net worth, then maybe you can spend a little. Take a trip, buy a new car, do some fun stuff but stay on your plan. And pay close attention. Maybe you should put off that new car a little longer. Work the plan.

    Ben Lis from NY posted over 2 years ago:

    Excellent article. And timely for me as well as I've been reviewing my overall asset allocation and the “3 Pockets” concept provides an excellent overall conceptual framework to guide my review.

    It motivated me to buy Tim McCarthy’s book “The Safe Investor” and I am happy I did. His views on country diversification are also informing my asset allocation review. The book provides very good advice on a number of investing topics.

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