It’s been proved time and time again that investment returns significantly outperform cash savings over time, yet millions of British savers are fearful of taking the plunge.
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The most common reasons why include a fear of losing money in market dips, and not being able to access the cash when you need it.
But one method can fix both of these fears, enabling long-term growth that has the chance to ride out volatility, while ensuring you can make withdrawals whenever you need them.
Enter the “three-pot method”, a clever framework to help you organise money in a way that works in the real world.
Here, Telegraph Money explains how this tactic works, and how you can use it to reach your financial goals.
What is the three-pot method?
The three-pot method involves, as you might have guessed, splitting your money into three. You’ll have one pot for short-term goals – the cash you want to be accessible whenever you need it; one for the medium-term – home improvements, for example; and the final pot for long-term goals, such as saving for retirement.
This framework can be effective because it matches money to time horizon and purpose before investment decisions are made.
It can also be sensible because it reduces the chances of short-term needs derailing long-term plans – needing to sell during a slump that would otherwise have been ridden out, for instance.
Harry Donoghue, a chartered wealth manager at Tideway Wealth, said: “Money naturally moves from long-term to medium-term, and then to short-term as goals get closer.”
The level of risk, he adds, should then be adjusted with that.
“When used properly, the three-pot framework makes investing feel more manageable – and helps people grow their wealth with greater confidence,” he said.
What’s more, when short-term needs are covered, people also tend to feel more in control and are far less likely to make rash decisions when markets are volatile.
Get it right, and you could find that it transforms your finances. So where do you begin?
Getting started
The first step in creating a pot-based approach is being clear about your short, medium and long-term goals. Having done that, you can then allocate a portion of your existing savings and income to each.
Let’s take the example of Mr Smith:
short-term goal: he dreams of going on a big trip a year from now
medium-term goal: he hopes to be able to buy a house in five years’ time
long-term goal: he wants to have a comfortable retirement.
With these set out, Mr Smith can then turn his attention to using the “three pots” framework to begin sketching out a plan.
The short-term pot
As this pot is all about money you may need within the next five years, the buzzword here is “certainty”.
The short-term pot could be earmarked for a specific block of spending, such as a big holiday (in the case of Mr Smith), a new car, a wedding, doing up your home and so on.
Sarah Coles, head of personal finance at Hargreaves Lansdown, said: “The fact you have a short-term horizon means cash is the best home for your money, because you won’t have time to ride out the ups and downs of the stock market.”
The type of cash account you then choose depends on what the money is for.
If you have a lump sum you’ll need in a year or so, it may make sense to pick a fixed-term savings account that lasts for the most appropriate period (you can commonly choose a duration of between one and five years).
Ms Coles said: “In some instances, you will make more interest by tying your money up, but crucially, it also gives you certainty over the return.”
If you need the money for an emergency fund, you’ll need an easy-access account.
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Worked example
Mr Smith saves £200 a month in an account paying 4.4pc for a year, giving him £2,449 to put towards his big trip.
Withdrawing the money after a year has no effect on his longer-term pots.
The medium-term pot
This is the home for money that is not needed immediately but which is likely to be required within the next five to 15 years.
This could be for a property move, a major home project, or any significant outlay – from supporting older family members to helping your adult children.
For this kind of timescale, you can consider investing in a stocks and shares Isa. While growth is never guaranteed, investing tends to have a far better chance of beating inflation than cash, and the longer time period means there’s more opportunity to stay the course through market ups and downs.
You can invest up to £20,000 a year, and pick from a wide range of options, including shares, investment trusts and funds.
James Scott-Hopkins, founder of wealth management firm EXE Capital Management, said: “Isas are perfect for building up medium-length savings as they can be easily accessed and grow free of both income tax and capital gains tax.”
However, you’ll need to carefully consider the level of risk.
Ms Coles said: “If, for example, you need to have a specific sum in six years’ time, you will want to take less risk than if you have 15 years and just want your money to work as hard as possible during that time.”
Diversification will be key, too, because different assets and geographies will tend to perform well in different market conditions. Having a mix will mean a more balanced performance overall.
Worked example
Let’s say Mr Smith slots away £200 a month into this pot. Assuming a 5pc return, over five years he’d end up with around £13,600 (after charges) for his property costs. Assuming the same return, over 10 years this pot could grow to just over £31,000.
Note that as you get closer to the time when you want to use the money, consider reducing the level of risk gradually.
Mr Donoghue said: “That way, it will naturally start to look more like the short-term pot, helping to protect the value when it matters most.”
The long-term pot
Given this is the pot where time really works in your favour, it’s worth doing all you can to start putting money away early.
By investing even small amounts regularly over a long period, you’ll be able to take advantage of compounding.
Sue Allen, of Chester Rose Financial Planning, said: “Long-term money, such as retirement savings, can take on more risk, focus on growth, and cope with market volatility, which should help improve returns.”
Typically, pensions will form the backbone of your retirement planning, but you may also want to hold Isas alongside to maximise tax-efficient income.
Mr Scott-Hopkins said: “For longer-term savings, pensions are the obvious choice. They cannot be accessed until age 55, and if you are employed, there is likely to be an employer contribution alongside your own to boost returns.”
In addition, you’ll receive tax relief on the money you pay in, and the pot grows free of both income tax and capital gains tax. However, there may be tax to pay when you come to make withdrawals.
If you’re choosing a workplace pension to save, it can pay to check it out first.
Ms Coles said: “If you don’t make a choice, you’re likely to be in a default fund which is a ‘middle-of-the-road’ option. Equally, if you want to take more risk in return for more potential growth over the long term, you will need to make some active investment choices.”
Worked example
According to analysis by Hargreaves Lansdown, if you’re 25 and putting £200 a month into a pension for retirement at the age of 67, then, assuming you’re starting with nothing today, you could build a pot of £291,500 – and get an income of £17,500 a year (plus your state pension).
This would undoubtedly help Mr Smith on his way to enjoying the comfortable retirement he’d hoped for.
Three-pot method pros and cons
Pros:
You can use it irrespective of how much money you have.
It’s an efficient way to take control of your finances; it helps you see things clearly.
Cons:
It’s easy to let the pots drift over time; if this happens, they’ll no longer be suited to their purpose.
They’re sensitive to changes in your circumstances (more below).
Remember to check in with your goals
Once you have your pots in place, they will need regular upkeep.
Ms Allen said: “You need to revisit them regularly. Circumstances change and without review, the risk in each pot can shift, meaning money ends up being invested in a way that no longer fits its original purpose.”
This, she added, is particularly important once you’re in retirement and in drawdown.
“Structuring money by time frame can help provide income with more confidence and reduce the need to sell investments at the wrong time,” she said.
content source: msn
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