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Bad things can happen and investments can turn sour short term

History tells us that over the very long-term, shares have done better than bonds, which have done better
than cash. History also tells us that there have been long periods of time when the reverse is true and
periods where shares fall significantly.

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The three recent major share market downturns were the share market crash of 1987, the bursting of the
tech bubble in 2000 and the sub-prime crisis of 2007 (that led on to the global financial crisis).

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In each “crash”, these were significant falls in the equity markets. It then took time before the value of
the markets recovered.

The conclusion when it comes to investing is that over the short-term, “bad things can happen”. They
have happened often in the past and there is no reason to think that they will not occur in the future.
The secret is to develop policies so that when they happen, you are not financially embarrassed.

History shows that sharemarket crashes tend to happen more often after a period of “excesses” which
have driven the markets higher, i.e. when the increased profits of the companies do not justify the share
prices. But when the markets appear to be too high, the timing of any correction is still unpredictable.
Markets can stay high for some time before there is a correction. When we see the markets rising and
look to be getting overpriced, we need to make sure that the money we have in shares is not money we
plan on spending short-term.

In most cases, when the market declines, the companies that suffer the most are those that have
borrowed a lot of money, or are yet to make a profit, or do not have the discipline of paying dividends.
Arguably, investors should be cautious about investing significant amounts of money in companies that
do not have a focus on consistently returning cash profits to shareholders. However, even if a share
portfolio targets companies that are profitable and make or provide goods that people want to buy, they
can still go down temporarily when bad things happen.

The bucket approach

Because we know bad things will happen, we need to develop strategies to manage the consequences.
The main challenge is to make sure that you do not have to sell an investment to meet expenditure, while
the market remains down. This is where we think the bucket approach to investing is one answer.

The bucket approach is designed to ensure that you are never forced to sell an asset to meet immediate
expenditure. It looks to invest your capital in a combination of cash, bonds, property and shares, based
on when you will spend it, and the levels of ups and downs in the value of your capital on each bucket
that you can tolerate.

Under the bucket approach, the capital allocated to shares and property, is money that you do not intend
to spend for 10+ years. This allows time for the share market to recover, should it suddenly decline.
Likewise, money allocated to bonds is money not intended to be spent for at least 3 years. This lets you
ride out the negative consequences of a rise in interest rates. Bad things can happen to bonds as well as
shares.

By adopting the bucket approach, an investor always has the money in the cash bucket that is likely to be
spent in the immediate future. At appropriate times, bonds mature or are sold, to top up the cash
bucket. Likewise, at appropriate times, shares/property investments are sold to top up the bonds
bucket. This gives the investor an orderly mechanism to manage the normal market fluctuations and get
through the periods when bad things happen.

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