What Is a Bucket?
The term "bucket" is used in business and finance to describe a grouping of related assets or categories. Buckets can contain investment assets that present a degree of risk, such as equities, or they can contain low-risk investments such as cash, short-term securities, fixed income securities with similar maturities, or swaps and/or derivatives with proximate maturities.
In managerial accounting, "cost buckets" are created to track unit-level costs.
- In investment vernacular, the term "bucket" is frequently used by portfolio managers, financial advisors, and their investment clients to describe a grouping of related investment assets.
- Buckets are routinely used as asset allocation tools, where portfolio managers assemble clusters (buckets) of investments, each with different risk characteristics, in order to create an overall asset allocation mix that best suits each investor, based on their individual risk temperament and long term goals.
- Nobel laureate James Tobin created a widely-followed investment strategy that is commonly referred to as the "bucket approach," which entails allocating stocks between a "risky bucket" that aims to produce high returns, and a "safe bucket" that exists for the purposes of meeting liquidity or safety needs.
Understanding a Bucket
"Bucket" is a casual term that portfolio managers and investors frequently use to allude to a cluster of assets. For example, a 60/40 portfolio represents a bucket containing 60% of the overall assets that are stocks and another bucket that contains 40% of the assets that are strictly bonds.
On the other hand, a fixed income-only portfolio of assets might contain a bucket of bonds with 5-year, 10-year, and 30-year maturities. A straight equity portfolio might contain a bucket of growth stocks and another bucket that contained only value stocks.
Although the bucket system lets investors intelligently allocate their capital to different investments, it is equally important to keep a substantial portion of one's portfolio in cash, to be able to take positions in viable investment opportunities, as they arise.
Buckets can be used to assess the sensitivity of a portfolio of swaps to changes in interest rates. Once the risk, or "bucket exposure", has been determined through a process known as "bucket analysis," the investor may choose to hedge that risk, if it is cost-effective to do so. A strategy called immunization may be used to create a perfect hedge against all bucket exposures.
Nobel laureate James Tobin developed a strategy dubbed the "bucket approach" to investing, which entails allocating stocks between a "risky bucket" that aims to produce significant returns, and a "safe bucket" that exists for the purposes of meeting liquidity or safety needs. To Tobin, the composition of the risky bucket would have little or no effect on the overall risk assumed by the investor, as long as the investor held two buckets.
Instead, changing the risk level would be achieved by altering the proportion of funds in the risky bucket, relative to the ratio of funds in the safe bucket. Tobin's bucket approach is widely seen as a simple and elegant investment solution. However, some proponents of the bucket strategy recommend using up to five buckets, as opposed to merely two.
In managerial accounting, direct material, direct labor, and overhead costs are placed into cost buckets for different products manufactured by a company. A cost bucket for Product X would contain each of the three cost categories as would Product Y. Managers would then be able to better estimate the unit-level costs of the products.
Personal Finance Bucket
"Bucket" is also used in the area of personal finance in relation to how individuals break up their assets. This is also often used in retirement. For example, buckets would be broken down into a short-term bucket, a medium-term bucket, and a long-term bucket.
The short-term bucket would contain assets for everyday expenses and those needed for the next two to three years. This bucket is most often cash or very liquid assets. The medium-term bucket would contain assets not needed for at least five to 10 years, such as dividend investments and real estate investment trusts (REITs). The long-term bucket would contain assets not needed for more than 10 years and would primarily be growth investments that would hopefully appreciate significantly over the time they are held.