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Divide and Conquer

Mike Gray
Senior Vice President | CAPTRUST Financial Advisor
Mark Paccione, CFA, CFP
Director | CAPTRUST Consulting Research Group

Every year one of our colleagues throws his own birthday party, typically a themed event with about 40 people attending. One of the most popular themes to date was “Bacon Fest,” where literally every food dish served at the party contained bacon, including the desert. Because it’s a recurring expense, he includes the cost of the birthday party in his annual budget right next to the annual payment for life insurance, which he now needs more than ever due to the large quantities of bacon he consumed. This year our colleague wanted a new set of golf clubs. As the annual household budget did not account for a new set of clubs, he had to figure out how to pay for them. His solution was simple — cancel the birthday party. By canceling the party, the clubs cost nothing, at least in his mind.

The funds had been mentally spent on the party months before during the budget process, so cancelling the party “freed up” funds that could be redirected from one discretionary expense slot to another. Behavioral finance experts refer to this phenomenon as Mental Accounting. This concept explores how individuals perceive and experience financial outcomes, how decisions are made and subsequently evaluated, and how financial activities are assigned to specific accounts or “buckets.”

By understanding mental accounting, investors are able to set up portfolios that are more congruent with their needs and thought processes. One approach is to split an overall portfolio into three buckets: (1) a liquidity bucket to support basic standards of living and immediate expenditures, (2) an income bucket designed for yield that seeks to maintain a standard of living and (3) a growth bucket for long-term, aspirational goals. The first bucket contains the safest and most predictable components of a portfolio such as cash instruments and short duration, high-quality Fixed Income investments. The second bucket possesses assets with more market risk and some growth potential including intermediate-term Fixed Income, preferred securities and dividend-focused Equities, while the third bucket holds assets with the greatest volatility and growth potential such as Small Cap Equities, Commodities, and Emerging Market Equities.

Through the use of mental buckets, an investor can potentially gain confidence that his or her immediate needs are planned for while decreasing anxiety over a portfolio’s more volatile growth components. The liquidity bucket serves as a continuous portfolio buffer and, as we have seen recently, the velocity of downside market moves makes hedging difficult if the hedge is not in place before the market decline begins. This approach can also help prevent investors from being too aggressive going into a market downturn and being forced into a more conservative allocation once the market has declined.

An investor who uses distinct buckets with specific objectives may be able to construct a portfolio better suited to his or her needs by potentially reducing the mental noise that distracts and often prevents investors from achieving their overall portfolio goals. CAPTRUST is here to further conversations on the concept as we work toward our shared goal of achieving your desired outcomes.

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