Bucket (Finance) - Explained
What is a Bucket in Finance
Written by J. Mance Gordon
Updated at April 22nd, 2024
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What is a Bucket in Finance?
Bucket refers to a term in finance and business that involves grouping of assets into categories. In managerial accounting, the personnel creates cost buckets to help them in tracking unit-level costs. Risk assets received by buckets include equities, risk-free or lower risk assets like short-term and cash securities, and fixed securities with the same maturities.
How Does a Bucket in Finance Work?
A bucket is a casual term that investors or portfolio managers use to group assets. For instance, a 60/40 portfolio denotes a 60% bucket stocks and 40% bonds. A portfolio with bonds only can be divided into buckets of say five, ten, and thirty-year maturities. On the other hand, a portfolio for equity can have a bucket stocks, bucket growth, and value stocks bucket. When it comes to the bucket approach, an investor usually divides his or her portfolio into several buckets. The transfers between those portfolios are usually done carefully thought structure. The first bucket can have enough cash as well as liquid assets. The other bucket has assets that are riskier. The bucket approach shifts an investor away from having only one investment portfolio.
About Bucket Approach
The bucket approach strategy for investing was created by a Nobel Laureate winner known as James Tobin. It involves the allocation of stocks between a risky bucket that produces returns and a safe bucket that meets safety or liquidity needs. However, to achieve a change in risk level, you need to change the funds proportion in the risky bucket relative to the safe bucket. This approach by Tobin has been termed as elegant and simple. However, there are those bucket strategy proponents who recommend the use of up to five buckets.
Why is Bucket Approach Important for Investors?
Investors can use buckets to determine how sensitive a portfolio of swaps is when it comes to changes in interest rates. Once an investor has assessed and is able to determine the risk (market exposure), he or she may decide to hedge the risk, if it happens to be cost-effective. To create a perfect hedge against all bucket exposures, investors can use what we call immunization.