Think of your money management choices as ingredients in a soup

Do you view your money as a soup or a salad? Do you slurp it or pick at it?

In other words, do you view your savings, investments and debt as one big thing, or do you have separate accounts in your mind for the different categories?

In my 40 years of planning, I have seen most people’s mental accounting drift toward a salad. For example, they have money in savings earning a low interest rate and some high-cost credit card debt. Or they live on a budget except for the one-time costs that occur every year.

Sometimes, mental accounting is what we use to justify choices making little financial sense. At other times, it gives us a false sense of security. Yet there are other occasions when it is quite useful.

One way to handle your money is by using a bucket approach. You could also think of it as ingredients to add to a soup.

One bucket is for money that has a direct purpose and that you plan on spending over the next three years. This bucket should be filled solely with safe vehicles that are also relatively liquid. In today’s environment, it can be sitting at a bank (although yields tend to be pretty uncompetitive here); online savings accounts that are linked to your bank; money market accounts that invest in U.S. treasuries (currently yielding almost 5%); or treasuries or certificates of deposit that lock in a rate for a little bit longer.

Money market accounts pay the most, but as interest rates fall, so will their yields. Locking some of your money up a little longer can protect those rates, even if their initial return is slightly lower.

The second bucket is for money you don’t anticipate needing for at least three years but no more than eight years. This bucket can be filled with a combination of stocks and bonds, or mutual funds that invest in those things. If markets perform poorly and you need some cash, you can sell your bonds first and let the stocks grow. If markets do well, then you can sell the stocks first for the cash you need.

The last bucket is for long-term growth and should be invested almost entirely in stocks. We prefer to have a combination of big, small and international stocks as a way to manage risk. As you get closer to needing the money, you would begin to move some of it into bucket two. When you get ready to retire, for example, you would move some of your spending needs into bucket one.

The key to this strategy is to honestly assess your time frames. During retirement, you still have three buckets: The money you will be living off of for the next three years will fill bucket one. Money that you anticipate spending in years three to eight should sit in bucket two. Lastly, you want bucket three to grow to replace some of the money spent in buckets one and two.

Too much money in buckets one and two don’t protect you against inflation; too little in one and two don’t protect you against market volatility. An appropriate strategy covers both effects.

These buckets are fluid, though.

If you are still adding to your portfolio, that means you decide into which bucket new money goes. Taxes can puncture a hole in the bucket, but you don’t want to be so tax averse that you accept more risk than you should simply to avoid paying taxes. On the other hand, when you look to reposition portfolios, you want to have enough conviction for your rebalancing so your certain tax cost is weighed against your potential investment gains.

If you delay taking Social Security, you will need more assets in bucket one to compensate, but you won’t need as much in that bucket when you start to collect.

Our money really is a soup filled with ingredients to ladle into our lives, but we tend to treat it as a salad, picking and choosing how we want to use it. Thinking in buckets is a recipe for success.

Ross Levin is the founder of Accredited Investors Wealth Management in Edina. He can be reached at ross@accredited.com.