Investing does not need to be complicated. In fact, it can be very simple and highly rewarding. If done right, you can potentially earn comparable returns to someone with sophisticated techniques.
When it comes to your investing approach, the range of options on how to do it is broad. You can use full-service financial advisors who will take care of everything for you. Or you can choose a DIY model where you’re in charge of making the decisions freeing you from advisory fees.
One really great way to invest simply is through a 3 fund portfolio.
This blog post will break down the key things you need to know about the 3 fund portfolio.
- What is the three-fund portfolio?
- Does the three-fund portfolio really work?
- Who is the three-fund portfolio for?
- Three fund portfolio asset allocation
- Tips before you get started with investing in a three-fund portfolio
- Alternatives to the three-fund portfolio
So, what is the 3-fund portfolio A.K.A. the lazy portfolio?
The three-fund portfolio strategy is an investing strategy where you create a portfolio that only contains 3 assets. These assets are usually low-cost index funds or ETFs.
More specifically, these funds can be broken down into the following asset classes:
- U.S. Stocks
- U.S. Bonds
- International Stocks
This method helps countless people grow their nest eggs handsomely. Plus, it's such an easy method and only takes a little time and energy. The most you will need to do is to occasionally monitor the performance of your assets and that will only take a handful of hours of your time over the entire year.
Does the 3-fund portfolio really work? What are its benefits?
For the investor looking for simplicity, the three-fund strategy may be a good option. But how does it work?
The hallmark of any good investment strategy consists of the following:
- Simple asset allocation
- Low costs
- Low risk
The three-fund strategy achieves all these goals and more securing higher chances of success. Let's get into each in more detail.
A well-diversified portfolio
The three-fund strategy allows you to diversify your portfolio without getting confused. This is because you don't have to figure out what to pick from thousands of stocks. With this strategy, you focus only on picking three funds. This eliminates the risk of being over diversified or not diversified enough.
Simplified asset allocation
With the three-fund strategy, simplicity drives the asset allocation strategy. U.S. stocks, bonds, and international stocks are typically the primary asset classes.
When looking at cost, a three-und investment strategy trumps other strategies on cost for a variety of reasons. Firstly, the strategy is subject to low expense ratios. Secondly, the turnover costs are low and lastly, from a tax perspective, the strategy is very efficient.
Costs matter because what seems like just a small percentage fee, can make a huge dent in your returns. The funds in a 3 fund portfolio are usually the least expensive relative to other funds you can choose from.
And finally, aside from the above benefits, there are other pros. For instance, there is no risk of advisor bias, unlike mutual funds. For example, some financial advisors may be biased in a particular direction towards a particular stock but with the three-fund portfolio, that risk is removed. This is because index funds are passively managed and broadly invested.
In addition, with each fund, rebalancing is very simple i.e. you set a predetermined asset allocation e.g. 33% stocks, bonds, and international stocks and if any of the asset classes fall out of alignment, then you simply rebalance your portfolio as needed, periodically.
Who is the 3-fund portfolio for? Beginners and hands-off investors?
So who would most benefit from this strategy? Surprisingly, this is perfect for the person who wants to exert the least amount of effort into putting together an investment strategy. It’s also a great approach for beginner investors. Some investing strategies involve an intense following of the day to day swings in the market, or complicated mathematical formulas – but not so with this strategy.
What about target-date funds as opposed to the 3-fund strategy?
These fund types consist of mutual funds that are in sync with your proposed retirement date. In other words, these funds grow with you as you age. For example, someone who is currently 30 might choose a fund with a target date that is 35 years from today. As time passes, the fund automatically rebalances based on risk according to your age.
While you are younger, the fund will take on more risk, but as you grow older, the fund will adjust towards less risky assets. The rebalancing process involves the intervention of a fund manager although, in the investor’s eyes, it all seems to happen automatically. The fund manager also chooses how the investments are made and the costs are passed on to you in the form of the annual management expense.
With the three-fund strategy, since it is more of a DIY approach, there is no active fund management, this means lower costs and you decide what funds your money is invested in. You'd, however, need to rebalance your investments according to your objectives on your own as time passes. This does not happen automatically like with a target-date fund. But, this rebalancing only takes a couple of hours a few times over the course of each year.
3-Fund portfolio asset allocation
As its name implies, the three-fund portfolio consists of three funds which as mentioned earlier are U.S. stocks, U.S. bonds and, international stocks. (If you are outside the US then the stocks and bonds would be local to your country).
While each three-fund portfolio consists of these elements, the actual allocation across each asset class can vary.
The most common way to set up a three-fund portfolio is with:
- An 80/20 portfolio i.e. 64% U.S. stocks, 16% International stocks and 20% bonds (aggressive)
- An equal portfolio i.e. 33% U.S. stocks, 33% International stocks and 33% bonds (moderate)
- A 20/80 portfolio i.e. 14% U.S. stocks, 6% International stocks and 80% bonds (conservative)
A few factors drive the decision on what allocation to choose:
1. Stocks vs. bonds: If you’re early on in your retirement trajectory, you may want to choose a portfolio that is more heavily weighted in stocks. This allows you to grow your portfolio more aggressively initially. Bonds, on the other hand, provide security but their returns are much more conservative.
2. Allocation percentages: In terms of allocation, you may be wondering how best to allocate between stocks and bonds. A really simple way to do it is to use your age with the “100 minus your age” formula. The way this works is that you simply assume your age is equal to the percentage share of bonds in your portfolio and the rest is allocated towards stocks.
For example, if you are 30 years old, you could allocate 70% to a total stock market fund and/or an international market fund (e.g. 60/10 split) and 30% to bonds and/or international bonds (20/10 split). If you are adding on REITs (Real Estate Investment Trusts), you could allocate 70% to stocks, 20% to bonds and 10% to REITs.
Tips before you get started with investing in a 3-fund portfolio
So now that you know how the three-fund portfolio works, here are some key things to consider before you dive into creating your portfolio:
Set clear objectives and goals
Before you get started, getting clear on your goals is crucial. While the three-fund investing strategy is undoubtedly easy, you will want to make sound decisions such as which brokerage you want to work with, how you will allocate assets across different categories and how much risk you would like to take.
Set up consistent investments (automate)
A long-term investment strategy is as good as the money you put into it on a recurring basis. While it is good to get your account up and running, it is even better to consistently contribute towards it each month. If you struggle with doing this consistently, the easiest way to stay consistent is to automate your deposits and investments.
Consider the 4% rule
Before you dive into any investment strategy, you need to ask yourself how much money you will need to retire comfortably. You will want to consider the type of lifestyle you are hoping to achieve and your long-term goals during retirement in order to figure out how much you will need to take out during retirement.
This is known as your withdrawal rate (adjusted for inflation) and it is the percentage of your portfolio that can be withdrawn per year, starting when you begin your retirement, without running short of funds. It can be hard to know all of this in advance, especially if retirement is still far away.
Experts have come up with a simple alternative to figure out your withdrawal rate. This simple formula is known as the 4% rule. An example of this is if you know you can comfortably live on $40,000 a year, then you would want your retirement nest egg to contain $1 million so that as you withdraw 4%, you’ll have enough to last your entire retirement (which typically averages 20 to 25 years).
Alternatives to the 3-fund portfolio
There are a few other simplified ways to invest similar to the three-fund that you could consider based on your preferences:
The one-fund portfolio
Investing in a total market fund. According to Warren Buffet, everyone, regardless of how simple or sophisticated their investment strategy is, should invest in an S&P 500 fund. An example is the Vanguard Total Stock Market Index Fund (VTSAX) which on average will give you the standard market return.
With this strategy, you invest in one total stock fund and you can choose one with a more diversified mix of stocks across large, medium and small-cap to capture the pros of each type of stock.
The two-fund portfolio
Investing in a total stock fund and bond fund. If you’re looking for additional security, the one fund portfolio might not be enough. It can give you good returns but it also carries a higher amount of risk. This risk can be countered by adding a bond fund to the portfolio.
Bonds are much more stable than stocks and tend to operate opposite to the way stocks do and can, therefore, stabilize a portfolio during swings in the stock market. An example of a bond fund is the Vanguard Total Bond Market Fund (VBTLX).
The four-fund portfolio
Investing in a total stock fund, bond fund, international stock fund, and international bond fund. As alluded to earlier, the ideal 3-fund portfolio will contain U.S. stocks, international stocks, and U.S. bonds. But those are not the only options.
Some investors may want something more diversified and would, therefore, add another fund. This can be in the form of international bonds such as the Vanguard Total International Bond Index Fund (VTIBX) which may carry more risk but offer room for higher returns.
The five-fund portfolio
Investing in a total stock fund, bond fund, international stock fund, international bond fund, and REIT fund. With four funds in your portfolio, you might consider yourself well-diversified which is not unreasonable. However, there are further ways to protect yourself from any negative downturns such as adding another type of fund to your portfolio e.g. REITs.
REITs stand for Real Estate Investment Trusts. The underlying assets in the portfolio are real estate properties – assets outside of the stock and bond markets. This can help with further diversification.
REITs are a great way to invest in real estate without having to physically deal with the property or tenant issues. An example is the Fidelity MSCI Real Estate Index ETF (FREL) which is a U.S.-centered REIT ETF that tracks the MSCI USA IMI Real Estate Index. It is built on about 174 holdings, which include data centers, public storage facilities, wireless tower companies and assisted living facilities and it is truly low-cost relative to other alternatives.
Leveraging a three-fund investing strategy can be a simple and effective way to build long term wealth. Be sure to do your research and understand any fees, and plan to invest over the long term.