Are you tired of managing 10 or more different funds in your retirement plan? Did your robo-advisor provide a list of even more funds, split between 8% in this fund and 17% in another? One reason many people shy away from managing their investments on their own is the seeming complexity required to achieve success. However, followers of the late Jack Bogle believe they have a better way.
Origins and popularity
The three-fund portfolio has gained popularity thanks to its simplicity and effectiveness. Jack Bogle (founder of Vanguard) believed that most investors could achieve better results by focusing on low-cost index funds rather than trying to beat the market through active management. His followers – known as Bogleheads – have long trumpeted the simplicity and potential for positive returns from using a three-fund portfolio.
Meet the three-fund portfolio
As its name implies, the three-fund portfolio involves diversifying assets across three key funds – a domestic stock fund, an international stock fund, and a bond fund. By utilizing this approach, investors aim to achieve a balanced and diversified portfolio that minimizes risk while maximizing potential returns.
Most adherents believe an 80/20 allocation between stocks and bonds is appropriate for many younger investors. The stock portion would be further divided between US and international stocks, so in the end you may choose 60% in US stocks, 20% in international stocks, and 20% in bonds. Naturally these percentages are just starting points – some new investors might want 100% in stocks, while those nearing retirement might choose to up the bond percentages.
Advantages
Diversification. One of the biggest advantages of the three-fund portfolio is its ability to provide a high level of diversification. By investing in a total stock market fund, you gain exposure to thousands of domestic companies across different sectors and market caps. Adding a total international stock market fund further diversifies your holdings to include companies from around the world. The total bond market fund provides stability and may help offset the volatility of stocks.
Simplicity. With just three funds to manage, it saves you from the headaches of constantly monitoring a large number of individual stocks or complex investment strategies. You don’t need to be a financial wizard or spend hours researching and analyzing companies. While not a set-it-and-forget-it approach, it definitely takes less time than managing and rebalancing a portfolio of individual stocks.
Lower costs. By investing in index funds, you avoid the higher expense ratios associated with actively managed funds. Additionally, index funds tend to have lower turnover, which can help minimize capital gains taxes. Over time, these lower costs and fees may significantly boost your overall investment performance.
Downsides
Lack of customization. While the three-fund portfolio provides broad market exposure, it does not allow investors to add particular sectors or themes. For investors seeking to invest heavily in specific asset classes or industries, the three-fund portfolio may feel too restrictive.
Potential underperformance. With the three-fund portfolio’s passive index fund approach, you may miss out on potential gains that others invested in more focused funds or individual stocks achieve. Additionally, the bond component may put a damper on your total return; some people may choose to limit or eliminate the bond portion while they are young.
Missing asset classes. The three-fund portfolio doesn’t include exposure to other assets like real estate, commodities, or alternative investments. If you believe these asset classes can provide additional diversification benefits or higher returns, you may need to look beyond the three-fund portfolio and consider other investment options.
How to get started
Choose the funds. Vanguard, Fidelity, and Schwab each offer low-cost index funds that align with the three-fund portfolio strategy. Researching and comparing different funds can help you make informed decisions and ensure the funds you choose align with your investment goals.
Set the allocation percentages. The allocation percentages within the three-fund portfolio can vary based on your risk tolerance, investment horizon, and financial goals. A common rule of thumb is to allocate a higher percentage to stocks when you have a longer investment horizon and a higher risk tolerance.
Rebalance. As market values fluctuate, the allocation percentages within your three-fund portfolio will deviate from your initial target. To maintain the desired balance and risk profile, periodically rebalance your portfolio. Rebalancing involves selling assets that have performed well and buying assets that have underperformed so your allocation percentages remain in the range you originally chose.
A three-fund portfolio will still experience market volatility
Investing in the three-fund portfolio does not shelter you from the normal ups and downs in the market. And as the recent bear market showed, bonds sometimes have down years at the same time stocks do. While diversification can help limit volatility versus holding a limited portfolio of individual stocks, there will be times when your portfolio’s value drops. Remember that this portfolio is designed for long-term investors who are willing to ride out market highs and lows. It requires patience and discipline to stay invested even during periods of volatility.
An alternate path
While many put every dollar in a three-fund portfolio, you may choose to invest differently. Some people use the three-fund approach for retirement planning or even college savings accounts while directing a small percentage of their portfolio to more focused funds or alternate investments (perhaps adding real estate or crypto to the portfolio). Advisors often compare this to visiting Las Vegas – only play with money you can lose (maybe 5% or less of your overall portfolio).
While there are many ways to build a portfolio, this approach has a vocal group of supporters. Visiting the Boglehead message board provides tons of more granular information. Do your due diligence and decide if this is the right approach for you.
Photo by Marianne Bos