'Bucket' strategy can help you stay ahead

By Joe Conroy

The Daily Record Newswire

With all of the market volatility recently, where can investors go to make sure they keep their investments safe?

All the news surrounding potential European defaults and America's debt crisis is leaving investors scared for their portfolios, and rightfully so. These volatile markets create a lot of anxiety, and cause many scared investors to flee to the perceived safety of savings accounts and CDs. This may seem like a prudent move, but it ignores some critical realities.

Banks offer FDIC-insured savings accounts and Certificates of Deposit (with certain account size limitations). These investment vehicles seem like a safe way to preserve the assets you have accumulated and avoid the turmoil of the markets.

Let's assume you deposit $100,000 into an account. Statements will start with $100,000 and will be guaranteed to have at least $100,000 or more with every statement thereafter. Of course, there are interest rates with some of these investments, so they will grow at the going rate for cash investments.

Each bank is different, but a lot of savings accounts are yielding next to nothing. CDs will fare somewhat better, and offer in the neighborhood of 1 percent to 2 percent depending on the time commitment. Those are guarantees that you can count on. In the unfortunate event that your bank collapses, your account is backed by the Federal Depository Insurance Corporation (assuming the balance is under the limits).

While the guarantees are nice, there is no such thing as a free lunch. There are hidden costs you pay for the safety of these accounts. I'm not talking about surrender fees if you liquidate a CD before it matures. These are costs that eat away at your account's real value, and are nearly invisible. By the time you realize the impact they have had on your money, it is too late.

Taxes reduce returns

The most obvious expense is the effect taxes will have on your returns. Returns will be reduced by the taxes owed on any gains.

For a couple that is married filing jointly and has taxable income of $100,000, their highest possible federal income tax rate is 25 percent. Let's assume that same couple is invested in short-term CDs paying (a very generous) 1 percent annual interest rate on a 6-month CD. Their 1 percent return would be reduced to 0.75 percent once you factor in the expense of taxes. This is still better than losing money in the market, right?

Our couple's positive return of 0.75 percent is missing one important factor when calculating their real returns. While their money was tied up in CDs, the cost of goods and services was increasing. With inflation of 1.5 percent in 2010 (according to the Consumer Price Index) their real return (after adjusting for taxes and inflation) goes from positive 0.75 percent to a negative 0.75 percent.

Once you factor in the costs of taxes on gains as well as the effect of inflation, it is very possible to lose purchasing power in CDs and savings accounts.

The issue with the loss of purchasing power is that it is very difficult to see in the short term. While money is parked in savings and guaranteed accounts, it looks like the dollar amount is staying the same or even increasing slightly. This feels good to the investor that has just gone through the "Lost Decade" and recent market volatility. However, while the investor may get better sleep now, inflation will chip away at their account's ability to purchase goods and services in the future, potentially leaving them shortchanged.

What to do?

If savings accounts and CDs have the ability to lose purchasing power through the effect of taxes and inflation, and the stock market is still too scary, what is an investor to do?

There are several options to help preserve the portfolio you have worked so hard to accumulate. Many investors have taken to a bucket strategy with immediate-term, short-term and long-term buckets. This strategy helps keep investors from making emotional mistakes when drawing money in retirement.

When markets are lower than historical averages, it makes sense to draw down your immediate- and short-term buckets, giving stocks the chance to recover. If markets are reaching all-time highs, it might make sense to take some gains from the long-term bucket.

Investing is not a week-to-week or month-to-month activity. To be a prudent investor you have to create systems and a strategy with the long-term picture in mind. This means protecting yourself from making mistakes based on emotions.


Joseph C. Conroy is a Certified Financial Planner with Synergy Financial Group in Towson. The opinions voiced in this article are for general information only and are not intended to provide specific advice or recommendations for any individual. Securities offered through LPL Financial, member FINRA/SIPC. Conroy can be reached at jconroy@sfgmd.com.

Published: Thu, Jan 12, 2012