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Would it ease the pain of the stock market decline this week to know that you have a five-year cushion to wait for a recovery?

When using the "bucket approach" to diversifying your investments, you largely avoid the stock market for money you'll need within the next five years. If you need your money sooner than that, you invest it more conservatively.

Think of the bucket approach as a rethink of standard portfolio diversification, where you mix stocks, bonds and cash according to your age, risk tolerance and financial goals. You'll still use stocks, bonds and more in your buckets, but everything revolves around when you'll need your money. "Ultimately, the challenge is to align each one of your investment-savings dollars with the time period during which you need it," said Brennan Carson, vice-president at Stylus Asset Management.

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Stylus uses four buckets when building portfolios for clients:

Bucket One: This is for money you'll need in the next six to 18 months, and thus can't be exposed to any risk of loss at all. High-interest savings accounts and guaranteed investment certificates are used here.

Bucket Two: For money you'll need in one to three years. Capital preservation is the objective, and bonds and preferred shares are examples of the type of investment options to consider.

Bucket Three: For money needed in three to five years. Investing options here include blue-chip stocks in less volatile sectors like utilities and telecommunications.

Bucket Four: For money you'll need in five years or more. This is where your broad stock market exposure goes.

Let's look in detail at the safety bucket (Bucket One) because it plays a big role in firming up your resolve to stay invested in stocks through the kind of plunges we saw on Monday, when gold prices reached their lowest point in two years and the S&P/TSX composite index fell 332.7 points, or 2.7 per cent. Ask yourself: How much money do I need to pay my fixed costs over the next year to year and a half?

Parents managing a registered education savings plan for an 18-year-old will want to have at least 12 to 18 months' worth of university or college costs locked down safely. If you're a retiree in your seventies or eighties, you might decide you want to have enough to pay your living expenses or meet the minimum withdrawal requirement for your registered retirement income fund for the next 18 months. "If you know your personal spending is $5,000 per month, then put $90,000 into a GIC or a bank account," Mr. Carson said.

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In Bucket Two, you increase the risk level somewhat to achieve better returns than you can with virtually zero-risk investments like GICs and savings accounts. Those parents of an 18-year-old might use this bucket to keep money that will pay their child's university expenses for the period between when Bucket One runs out and graduation. A 70-year-old might use this bucket for an additional 18 months of living expenses.

Note: The kind of investments used in Bucket Two can lose money. While bonds mature and repay your investment, rising interest rates would lower the price you'd get if you sold before the maturity date. Preferred shares are much less volatile than the more widely followed common shares, but the experience of 2008-09 shows they can still fall significantly in price.

"Do bonds and preferred shares ever go down? Absolutely, they do," Mr. Carson said. "But, of course, they go down less than stocks, and that means it doesn't take as much time to recover."

For the third bucket, Mr. Carson suggests sticking to what investing professionals call "low-beta" stocks or funds. Beta is a measure of stock market volatility, and low-beta means a history of fluctuating less in price than the appropriate benchmark stock index.

Examples of low-beta stocks include BCE Inc. and Canadian Utilities Ltd., both of them dividend-paying blue chips that far outperformed the S&P/TSX composite index through the ups and downs of the past five years. Another possibility is a new category of low-beta equity funds that have been introduced lately in the BMO, iShares and PowerShares exchange-traded fund families.

For a very rough indicator of how much less volatile low-beta stocks might be, Mr. Carson pointed to the performance of the Stylus Value With Income Fund, which is used for Bucket Three money. The fund was off 0.9 per cent for the first two and a half weeks of April, while the S&P/TSX composite index was down 5.8 per cent.

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Bucket Four is where you put broad stock market exposure. In fact, Mr. Carson suggests using stocks and funds that emphasize capital gains over dividends. If you lose money in a year, take comfort in the fact that your short-and medium-term needs are looked after.

Is it realistic to expect stocks to recover losses in five years? Even with the crash of 2008-09 included, the S&P/TSX composite index was still up an average 2.1 per cent over the five years to March 31. Monday's stock market plunge is the kind of thing that puts investors in a defensive frame of mind, but it's also possible that the next five years could bring solid stock market gains.

Mr. Carson said these profits can be used to rebalance your buckets annually. For example, you could draw money out of buckets Three or Four and use it to replenish the safe but low-return money in Bucket One. You can also use income drawn from Bucket Two for rebalancing.

Traditional diversification is based on the idea that age should be the main factor in setting exposure to stocks and bonds. Mr. Carson said his firm doesn't look much at age, and it also dispenses with the usual industry phrases for describing investors in favour of looking at an individual's actual needs. "Around here, when we meet with clients we don't talk about aggressive or conservative, we talk about time horizon and personality. It takes age off the table."

Read more from Portfolio Strategy.

For more personal finance coverage, follow Rob Carrick on Twitter (@rcarrick) and Facebook (robcarrickfinance).

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Personal Finance Columnist

Rob Carrick has been writing about personal finance, business and economics for close to 20 years. He joined The Globe and Mail in late 1996 as an investment reporter and has been personal finance columnist since November 1998. Rob's personal finance columns appear in The Globe on Tuesday and Thursday, and his Portfolio Strategy column for investors appears on Saturday. More


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