If you want to uncomplicate investing, a three-fund portfolio approach can be a simple way to growth wealth over time. This strategy involves choosing three mutual funds or exchange-traded funds (ETFs) to create a diversified portfolio. The three-fund portfolio is often associated with the Bogleheads, named after Vanguard founder John Bogle. It’s a lazy way to invest, but is it right for you? Understanding how it works and the pros and cons of investing in just three funds can help you decide. A financial advisor can help you set up a portfolio that reflects your goals, timeline and risk profile.
What Is a Three -Fund Portfolio?
A three-and portfolio is an investment portfolio that’s built around three funds. In a typical three-fund portfolio approach, this includes:
A domestic stock index fund
An international stock index fund
A bond index fund
These can be mutual funds or exchange-traded funds. Index funds are a popular choice for a three-fund portfolio because they can offer simplified diversification with moderate risk and moderate cost. By tracking an entire benchmark or market index, you can gain exposure to all of the assets in that index.
Three-fund portfolios are designed to provide a comprehensive approach to diversification since they include both domestic and international stocks as well as bonds. The goal is to choose funds that represent the market as a whole.
The weighting for each of the three funds can depend on your risk tolerance, time horizon and objectives for investing. If you’re still 30 years away from retirement, for example, then you might have an 80/20 split. In this case, 80% of your portfolio is allocated to stocks and 20% is allocated to bonds. Within the stock segment of your portfolio, you’d have to decide how much to allow to U.S. stocks and how much to allocate to international stocks.
But that’s one of the most appealing features of the three-fund portfolio. It’s very easy to customize and tailor to your needs.
Pros and Cons of a Three-Fund Portfolio
As with any investing strategy, there are advantages and disadvantages to using a three-fund portfolio approach. Looking at both sides can help you decide whether it makes sense for you. Now let’s get into the specific pros and cons of the three-fund portfolio.
Pros of a Three-Fund Portfolio
Simplified diversification. Diversifying your portfolio matters for managing risk. A three-fund approach can make it easier to diversify if you’re choosing funds that reflect the market as a whole.
Lower costs. Using index funds to construct a three-fund portfolio may be more cost-effective overall. Since index funds follow a passive investing strategy, they’re typically less expensive than actively managed funds.
Invest with ease. Investing can be overwhelming to a beginner and it may be challenging for seasoned investors from time to time. A three-fund portfolio lets you keep things as simple as possible while building wealth.
Cons of a Three-Fund Portfolio
Returns.Index funds, by nature, are designed to match the market not beat it. So if your goal is to achieve above-average returns, a three-fund approach may not suit your needs in terms of performance.
Rebalancing.A three-fund portfolio is not set-it-and-forget-it. You will still need to pay attention to your overall allocation and rebalance when necessary to stay aligned with your investment goals.
No room for alternatives. Using a three-fund approach to investing in its truest sense means sticking with the domestic stock, international stock, bond index fund formula. Investing in real estate or cryptocurrencywould mean straying away from the core of how a three-fund portfolio works.
Example of a Three-Fund Portfolio
A three-fund portfolio isn’t complex. It just means choosing one representative fund to include in your portfolio from the domestic stock, international stock and bond categories. These funds can all belong to the same family or come from different mutual fund companies. And you can substitute ETFs in place of mutual funds.
So, for example, say you want to build a three-fund portfolio using Vanguard index funds. Your portfolio might look like this:
Vanguard Total Stock Market Index Fund (VTSAX) – 60% allocation
Vanguard Total International Stock Index Fund (VTIAX) – 20% allocation
Vanguard Total Bond Market Fund (VBTLX) – 20% allocation
Now, say you want to choose ETFs instead but you want to lean more heavily on domestic stocks. Your portfolio might look like this:
Vanguard Total Stock ETF (VTI) – 70% allocation
Vanguard Total International Stock ETF (VXUS) – 10% allocation
Vanguard Total Bond Market ETF (BND) – 20% allocation
The funds you choose don’t all have to come from the same place. For example, you could choose one Vanguard fund, one Fidelity fund and one fund from Charles Schwab. The goal is to stick with the three-fund allocation, with one fund from each category.
How to Build a Three-Fund Portfolio
Constructing a three-fund portfolio is meant to be as simple as possible. You can do so through an online brokerage account. The first step is deciding which funds to invest in; the second is choosing how much of your portfolio to allocate to each one.
When evaluating index funds or ETFs, start by looking at what each fund invests in or which index it tracks. A total stock market index fund can offer broad exposure to the entire market. A fund that tracks only the S&P 500 or the Russell 2000, on the other hand, is more narrowly diversified since you’re only getting exposure to a segment of the market.
Next, compare the costs for different funds. Specifically, look at the expense ratio. Ideally, you’re trying to find broad index funds that offer the highest level of diversification and returns with the lowest cost profile. If you’re considering funds with a higher expense ratio, look at the performance and historical track record of the fund to judge whether it’s worth the added cost.
Finally, think about how much you want to allocate to each fund in your portfolio. This can depend largely on how long you have to invest and your risk tolerance. The younger you are, the more of your portfolio you can likely afford to allocate to stocks. But keep in mind that stocks are risky and international stocks have the potential to be riskier than domestic ones.
Bonds can offer a safer counterbalance to stocks. Allocating too much of your money into bonds early in your investing career could cost you returns, however. Talking to your financial advisor can help you decide which funds might suit your needs the best.
The Bottom Line
A three-fund strategy may work well for you if you want to keep investing as simple and hassle-free as possible. While you likely won’t beat the market with this approach, you can build wealth for retirement consistently over time. Just remember to pay attention to fund expense ratios and trading fees, as these costs can detract from the returns you’re earning.
Tips for Investing
If you’re still not sure whether a three-fund portfolio might be right for your financial plan, consider speaking to a financial advisor who can help you figure it out.Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
Target date funds offer an alternative to index funds and the three-fund portfolio strategy. These funds base their asset allocation on a target retirement date, i.e. 2045, 2050, 2055, etc. If you have a 401(k) plan you invest in at work, you likely have target date funds as an investment option. While target date funds can also simplify investing, it’s important to consider the type of returns they might produce and what you might pay to own them.Photo credit: ©iStock.com/fotofrog, ©iStock.com/Cecilie_Arcurs, ©iStock.com/Henrik5000
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