The problem with a 3 fund portfolio

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Dulocracy
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The problem with a 3 fund portfolio

Post by Dulocracy » Thu Oct 10, 2013 2:28 pm

Let me begin by saying that I am in no way an expert, so I welcome experts to argue these points. I want to know if I am wrong. However, there are two problems with a 3 fund portfolio that I see.

1) The first problem is that it is too simple. That expression about keeping things as simple as they can be, but not more simple? That applies here from what I see. Here is why: If I have Total Bond, Total Stock Market, and Total International, regional fluctuations cannot be separated from the fund. That is: If Europe starts doing really well, but Asia crashes, all of my money is in one fund that has both. This is only a problem under two circumstances, but it is a big problem if either applies.

1) A) Circumstance 1 is the disbursement phase of life. If I have all of my international holdings in Total International, taking money out may lock in losses. If Europe is doing well and Asia is not, selling this fund will lock in losses in Asia. If Asia is doing well, but Europe is not- selling locks in losses in Europe. Only if both Asia and Europe are doing well is this a good fund to sell. I would rather be able to have a separate fund for Europe and one for Asia. That way, if Europe is doing well, I can rebalance by cashing in the European fund while it is doing well. This way, I am always taking from the winners while rebalancing. In a Total International fund, this is not possible. Yes, one would lose out on the 10% of the fund that is in Africa, Canada, South America, and whatnot, but that could either be resolved by getting a couple of small holdings in said funds or ignoring those regions in order to be able to have money in a format more flexible (that does not force locked-in losses).

1) B) Which leads to rebalancing. If I want to have 40% Asia and 60% Europe, I cannot control that in Total International. If someone asks why the proportion is important? I would ask why it is important to assign to total international vs. total US. As economic regions, Europe and Asia perform very differently. I am not arguing to the absurd of going so far as to have a fund for Norway and a different one for Sweden, but major economic groupings seem like they would best be given a portion and kept separately best allow for rebalancing to goal.

2) The second point is not that 3-fund is inappropriate for all people, but it is for some on the following grounds: The oversimplification can cause a psychological problem with maintaining a portfolio. That is, if the total stock market is down, someone may panic and sell. If one portion is down, but another is not, it is more likely to remind people that part of the portfolio is acting differently than the rest. It is easier to stomach a crash in 20% of a portfolio than in 50%. Personally, I will look for which fund is doing the worst in order to add a couple of hundred dollars. This is not to say that the money actually matters, but the symbolism of the action reminds me to stay the course. It is a reminder to buy low, sell high, and that the market will likely recover. This is NOT to say that one market times (notice it is only a few hundred that I put in for the symbolism). The point is that a 3 fund portfolio may cause some to panic out of whatever third of their portfolio is crashing right when they would lock in the worst losses. Psychologically, having multiple funds would allow the person to look at the portfolio more as a unit with parts that move independently of each other and work together in the end rather than as a single hot potato that will burn more if they hold it longer.

In summary, the main problems that I see with a 3 fund portfolio are that it can force someone who is taking distributions to lock in losses, and it can work against the psychology of some investors.

Your thoughts? (This is what makes this actionable. In full disclosure, while Ferri and Swedroe sometimes butt heads, my investment strategy evolved from a lot that I have read in their books. I currently have 9 fund categories in my asset allocation. I will be watching the comments here to evaluate my understandings that underlie the method by which I picked a portfolio asset allocation.)
I'm not a financial professional. Post is info only & not legal advice. No attorney-client relationship exists with reader. Scrutinize my ideas as if you spoke with a guy at a bar. I may be wrong.

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Re: The problem with a 3 fund portfolio

Post by leonard » Thu Oct 10, 2013 2:47 pm

Naw, it's a great solution for most.
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Re: The problem with a 3 fund portfolio

Post by InvestorNewb » Thu Oct 10, 2013 2:55 pm

I don't mean to offend, but these are not good arguments against the 3-fund portfolio.

Criterion #1 : A good argument must have true premises
Criterion #2 : A good argument must be either valid or strong
Criterion #3 : The premises of a good argument must not beg the question
Criterion #4 : The premises of a good argument must be plausible and relevant to the conclusion
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Re: The problem with a 3 fund portfolio

Post by nisiprius » Thu Oct 10, 2013 2:59 pm

Dulocracy, I disagree. I can't speak for everyone, but I think quite a lot of investors are like me: if I have a single fund, I look at the fund as a whole and really do ignore the relative performance of its component parts. But if I have several funds, I just can't avoid paying attention to their relative movements, and instead of feeling good that something is always doing well, I tend to feel bad because something is always doing poorly.

Even with something as simple as a three-fund portfolio, with separate U.S. and international funds, in 2010 when international started to lag U. S., there were quite a few posts with titles like Time to Bail Out of International Funds? And whether you interpret such an event as "Time to bail?" or "Buying opportunity" the fact remains is that you fret about it and are in serious danger of doing something other than leaving things alone until you actually hit a rebalancing band.

Secondly, I am not sure you appreciate the point that rebalancing isn't magic. It only increases returns if the asset classes really display mean reversion, and only then if your rebalancing strategy is gauged to result in rebalancing over periods of time over which mean reversion occurs. It's not a magic thing that automatically ratchets up returns, provided only that the assets are imperfectly correlated. You need asset pairs that have comparable return, comparable volatility, and low correlation.
Last edited by nisiprius on Thu Oct 10, 2013 5:29 pm, edited 3 times in total.
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Re: The problem with a 3 fund portfolio

Post by Aghast » Thu Oct 10, 2013 3:10 pm

The Total International fund is a market-cap-weighted portfolio, so if Europe is booming and Asia crashes, the allocation to Asia would be smaller, so if you were to withdraw from the fund, you would be withdrawing proportionately more from Europe, correct?

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Re: The problem with a 3 fund portfolio

Post by nedsaid » Thu Oct 10, 2013 3:52 pm

I have found that with investment products and strategies: the fewer moving parts the better. If you don't know what else to do, a three fund portfolio is better than what most other people come up with.

The problem with investments is that we overthink things. Just because you develop convictions about what the market is going to do doesn't mean that the market has to obey your convictions. For example, a lot of experts cited the recession in Europe and problems with the Euro. The word on Wall Street was "avoid Europe." What happened? The European stock markets went straight up.

Complicated investment strategies based on complicated scenarios of how various world events and economies play out break down over time. The more elements to your strategy, the more likely you are to be wrong about something in it.

I am a "slice and dice" guy myself. I am trying to capture the premiums that Larry Swedroe talks about. But I have no argument with someone who wants a simple three fund portfolio.

My big point that I want to get across to my fellow investors is be very broadly diversified across the world stock markets and the US Bond Market. I have International Bonds in my portfolio as well but don't think these are necessary for an individual investor. Diversify, diversify, diversify.
Last edited by nedsaid on Thu Oct 10, 2013 4:37 pm, edited 1 time in total.
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Re: The problem with a 3 fund portfolio

Post by Dulocracy » Thu Oct 10, 2013 4:06 pm

Kindof disappointed in this response. The others will require a bit more time to respond to, so I will do so separately. This is a very disappointing post, but I want your reasoning, so let us delve.
InvestorNewb wrote:I don't mean to offend, but these are not good arguments against the 3-fund portfolio.

Criterion #1 : A good argument must have true premises

If the premises used are incorrect, please explain HOW they are incorrect. From my argument above, I will put this in Aristotle’s argument using two premises. International funds hold all international funds in proportion to their value. When selling a fund, you sell all assets within said fund. Therefore selling a Total International fund sells all of the assets proportionally which are held by the fund.

Taken to the next step: Selling stock during a crash locks in your losses. If you sell International funds, you sell all stock proportionally within the fund. If there is a crash in a part of your fund, you would be locking in losses by selling.

My argument (which is not meant to persuade, but to open dialogue) is that having a total fund can cause you to lock in losses when you are in the distribution phase of life. If Europe’s funds are down and Asia’s are up, I would rather just sell the Asia portion, rather than locking in losses in Europe. This sounds logical to me. I am asking for a response that gives a good argument for the other side.


Criterion #2 : A good argument must be either valid or strong

First, saying “Your argument isn’t valid” without explaining WHY does not hold weight in any debating circles that I know. Please, tell me why you think the argument is wrong. (We are past the playground days of calling each other meany cheater heads.)


I must poke a little fun at you, so please take it in a good humored way: A good argument must either be valid OR strong. So, even if the argument is logically invalid, it is good if I assert it strongly enough?

Criterion #3 : The premises of a good argument must not beg the question

Agreed. With the exception of some rhetorical usage for public speech, begging the question is bad. I do not believe that I have done that here. As with many debates, I started by telling you what I was going to explain. I explained it. I then followed up by telling you what I explained. Do not overlook the actual guts of the argument… the part where I laid out supporting scenarios. Forgive me if using a more formal debate format made it look like I was basing the answer in the question. I was proposing an idea… giving the logic behind the idea… then restating said idea.

Criterion #4 : The premises of a good argument must be plausible and relevant to the conclusion

It is plausible that Asian markets and European markets would act differently at different times. It is also plausible that by selling a fund which had shares that were low, you would therefore lock in losses. Finally, it is relevant that if I have a fund that sells everything at once, I will sell losers at the same time as winners, whereas I could just sell the winners if the matter was separate.
I hope that this encourages you to use examples and logic to explain to me why I am wrong. Again, I am not trying to convince anyone, but I am trying to hear reasons why people think this logic is wrong. A lot of smart people like 3-fund. I would like to understand it better. This is where I stand in my path. If you think another path is better… lead me there. Do not simply yell at me for being on the wrong path.
I'm not a financial professional. Post is info only & not legal advice. No attorney-client relationship exists with reader. Scrutinize my ideas as if you spoke with a guy at a bar. I may be wrong.

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Re: The problem with a 3 fund portfolio

Post by Rodc » Thu Oct 10, 2013 4:08 pm

Democracy is a terrible form of government. Only issue is all other forms are far worse.

The three fund is not perfect. In fact I don't use it. But it is a very fine way to go, might in fact in the end be optimal even if it has warts. For certain even if not optimal there are nearly an infinite number of worse ways to invest and darn few that are better.

This will put you in the top few percent of all investors if you stick to it for a few decades.

Added: it has all the important bases covered: low cost, well diversified to start. Easy to implement and follow. Because it hides a lot of variance at any given time between regions or market segments it is less likely to cause emotional mistakes (better in this respects is a blended stock/bond portfolio). Because it is simple it is less likely to cause an investor to fiddle into buy high sell low market timing.
We live a world with knowledge of the future markets has less than one significant figure. And people will still and always demand answers to three significant digits.

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Re: The problem with a 3 fund portfolio

Post by MIretired » Thu Oct 10, 2013 4:25 pm

Aghast wrote:The Total International fund is a market-cap-weighted portfolio, so if Europe is booming and Asia crashes, the allocation to Asia would be smaller, so if you were to withdraw from the fund, you would be withdrawing proportionately more from Europe, correct?
This is a "plus" in favor of a 3-fund.
If VGTSX has 15%EM, 30%PAC, and 55%EUR (tho it doesn't hold those funds, but the regions), and EM and PAC tank in half and EUR stays level. VGTSX will then be 71%EUR, and if you sell, your sale will be 71% in EUR, 29% in EM and PAC. Instead of the 45% EM and PAC. And you're also not timing the gains/losses that way.

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Re: The problem with a 3 fund portfolio

Post by Dulocracy » Thu Oct 10, 2013 4:39 pm

nisiprius wrote:I disagree. I can't speak for everyone, but I think quite a lot of investors are like me: if I have a single fund, I look at the fund as a whole and really do ignore the relative performance of its component parts. But if I have several funds, I just can't avoid paying attention to their relative movements, and instead of feeling good that something is always doing well, I tend to feel bad because something is always doing poorly.

Which is understandable. My point in the second criticism was not that 3-fund is flawed in that way, but that it may not work for all people. I am probably not going to do as well at staying the course with a 3-fund with my current mentality/understanding of it. The criticism is not that 3-fund is bad, but that it is often portrayed as the BEST way for all situations. Sometimes, because humans are weird, it may not be best for all people. Simple works better for my wife, for example.

...
Secondly, Dulocracy, I am not sure you appreciate the point that rebalancing isn't magic and only increase returns if the asset classes really display mean reversion, and only then if your rebalancing strategy is gauged to result in rebalancing over periods of time over which mean reversion occurs. It's not a magic thing that automatically ratchets up returns, provided only that the assets are imperfectly correlated. You need asset pairs that have comparable return, comparable volatility, and low correlation.

In a search for brevity in a long post, I was inarticulate. I will delve into my primary thoughts about rebalancing in the next section... as it is precisely the times of low correlation that I am talking about in my criticism.
Aghast wrote:The Total International fund is a market-cap-weighted portfolio, so if Europe is booming and Asia crashes, the allocation to Asia would be smaller, so if you were to withdraw from the fund, you would be withdrawing proportionately more from Europe, correct?
Yes and no. Let me show you an example of what I am thinking.

To make this easy, we are going to say we have a Total Fund that invests in imaginary lands. Call them Fanelia and Zaibach. The fund is 50% in Fanelia and 50% in Zaibach. Now, I have $100,000 in the fund. The shares owned in Zaibach are 1000 shares spread over 100 companies (easy numbers). The same goes for Fanelia shares. With me so far? The Zaibach part of the fund increases to $75,000 in value (with those 1000 shares in 100 companies), but the Fanelia portion reduces to $25,000.

Now, Zaibach shares are worth $75 per share (remember, the value changed, but the number of shares did not.) Fanelia shares dropped to $25 per share.

I need to take $10,000 out. I remove it from the Total Fund. The money comes proportionally, so $7,500 from Zaibach and $2,500 from Fanelia. Easy enough. Now, my $90,000 owned in Total Fund has 900 shares of Zaibach and 900 shares of Fanelia.

As the two do not always correlate, the world changes. Fanelia does well and Zaibach slips. Now Fanelia has shares worth $75 each and Zaibach has shares worth $25 each. In my Total Fund, I have $90,000. Even, correct?

My issue comes in at this point. If the funds were separate, you could have sold Zaibach shares when it was doing well to get the full $10,000 that you needed. This would result in owning $65,000 in Zaibach and $25,000 in Fanelia. You would have sold 133.33 shares from your Zaibach portion. You would then have 866.7 shares of Zaibach and 1000 of Fanelia. When the tables turned so that Fanelia was doing well, you would have $21,667.50 in Zaibach and $75,000 in Fanelia for a total of $96,667.5 in the portfolio. As it is separate, when you have to take the distribution again, you take it from Fanelia's Fund.

Yes, these are simple numbers for illustration purposes. The concept, however, is that having some separation allows you to sell the winners. Whether or not someone rebalances, my main point was that in distribution phase, a total fund could result in lower returns than separate funds. Substitute Fanelia and Zaibach with Asia/Europe or Small/Large or what have you, the argument I was trying to present is that because a Total Fund requires you to sell all at once, you could be forced to lock in losses when you need the money. Separating the money could help avoid this. That is my logic, and the reason that I posted asking for people with different views. How do proponents of the 3-fund view this? If there is an error in a premise, what is that error? I look forward to the responses.
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Re: The problem with a 3 fund portfolio

Post by fauji » Thu Oct 10, 2013 5:04 pm

I am no expert here but my naive thinking will suggest that in case of emergency or disbursement phase one will want to withdraw proportionally from a 3 fund portfolio. Why would one want to cherry pick what to sell ? Thoughts ?

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Re: The problem with a 3 fund portfolio

Post by FinancialDave » Thu Oct 10, 2013 5:20 pm

I am not sure what kind of argument the OP is trying to make. The only argument for saying some other group of funds is going to do better is if you can predict the future.

Sure the math of history may tell you something else might have done better in the past, but that does not help you going forward.

In fact, after you have sifted through all these arguments and have picked your asset allocation, I challenge you to put an equal allocation in one Total Stock Market Fund such as VTSAX. Come back in 10 years and tell me which has done better, your 4-10 funds or the one Total Stock Market Fund.

Of course this is only useful if your goal is to maximize your return, because if you want a certain risk profile that includes bonds it won't be a fair test as VTSAX will leave you in the dust long term (IMHO.)

This is the only true test of your hypothesis. You can play it all out on paper as much as you want, but the true test "is in the pudding."

fd
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Re: The problem with a 3 fund portfolio

Post by ruralavalon » Thu Oct 10, 2013 5:21 pm

Vanguard Total International Stock Index Fund Admiral Shares (VTIAX), is market weighted so the fund automatically rebalances when any area or cap size outpaces any other. It does capture the rebalancing benefit, OP is incorrect to assume that it does not.

And there is a rebalancing benefit only when there is meaningful dis-correlation between areas or cap sizes. That is not always present (remember 2008?).
Everything should be as simple as it is, but not simpler." - Albert Einstein
This is not an argument against using the three total market type funds, nor an argument for using instead the component parts of any of them. It is an argument for using additional mutual funds that can supply some area of investment not found in, or under-represented in, the three funds. Examples: international bonds; more real estate; and perhaps more corporate bonds.

Finally, the cure for anxiety in volatile markets is a higher fixed income holding, see: "An Efficient Frontier: the power of diversification". I don't see how the ability to be more active in rebalancing in your stock holdings can cure that anxiety.
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Re: The problem with a 3 fund portfolio

Post by nisiprius » Thu Oct 10, 2013 5:40 pm

Dulocracy wrote:The criticism is not that 3-fund is bad, but that it is often portrayed as the BEST way for all situations. Sometimes, because humans are weird, it may not be best for all people. Simple works better for my wife, for example.
I think that's a straw man.

Are people really saying that a simple portfolio is best, but that it there isn't convincing evidence that anything else is better. Now this is a very different claim. In fact, I think there are a large number of portfolios and strategies for which one can say there isn't convincing evidence that anything else is better. For example, there's no convincing evidence that slice-and-dice is better than three-fund, AND no convincing evidence that three-fund is better than slice-and-dice.

Bogle, himself, makes an even weaker claim:
There are an infinite number of strategies worse than this one: Commit, over a period of a few years, half of your assets to a stock index fund and half to a bond index fund. Ignore interim fluctuations in their net asset values. Hold your positions for as long as you live, subject only to infrequent and marginal adjustments as your circumstances change. When there are multiple solutions to a problem, choose the simplest one.
The real question, then, is what's the harm in being an investing gadget freak who relishes a little complexity, if it doesn't cost much? Probably not much.

There's some danger in kidding yourself that you know more than you know, or that you are in more control of the situation than you are.

Also, it's my cranky opinion that there is a systematic, self-serving bias in Wall Street's marketing, and that there is a constant push in the direction of more risk, and more complexity, which needs to be consciously resisted.
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Re: The problem with a 3 fund portfolio

Post by ddj » Thu Oct 10, 2013 6:33 pm

FinancialDave wrote:The only argument for saying some other group of funds is going to do better is if you can predict the future.

fd
+1
Dulocracy wrote: My issue comes in at this point. If the funds were separate, you could have sold Zaibach shares when it was doing well to get the full $10,000 that you needed. This would result in owning $65,000 in Zaibach and $25,000 in Fanelia. You would have sold 133.33 shares from your Zaibach portion. You would then have 866.7 shares of Zaibach and 1000 of Fanelia. When the tables turned so that Fanelia was doing well, you would have $21,667.50 in Zaibach and $75,000 in Fanelia for a total of $96,667.5 in the portfolio. As it is separate, when you have to take the distribution again, you take it from Fanelia's Fund.
For the sake of argument, then, pretend that Fanelia is Japan in 1991 and Zaibach is, say, some other developed country. Can you stomach a lost decade or two (and does it behoove you to gradually sell off most of your Zaibach and wait and wait and wait for Fanelia to bounce back)? I couldn't; it doesn't.

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Re: The problem with a 3 fund portfolio

Post by MIretired » Thu Oct 10, 2013 6:39 pm

ruralavalon wrote:Vanguard Total International Stock Index Fund Admiral Shares (VTIAX), is market weighted so the fund automatically rebalances when any area or cap size outpaces any other. It does capture the rebalancing benefit, OP is incorrect to assume that it does not.

And there is a rebalancing benefit only when there is meaningful dis-correlation between areas or cap sizes. That is not always present (remember 2008?).
Everything should be as simple as it is, but not simpler." - Albert Einstein
This is not an argument against using the three total market type funds, nor an argument for using instead the component parts of any of them. It is an argument for using additional mutual funds that can supply some area of investment not found in, or under-represented in, the three funds. Examples: international bonds; more real estate; and perhaps more corporate bonds.

Finally, the cure for anxiety in volatile markets is a higher fixed income holding, see: "An Efficient Frontier: the power of diversification". I don't see how the ability to be more active in rebalancing in your stock holdings can cure that anxiety.
The fund follows an index(FTSE global all-cap ex-US, in wiki) which is reviewed, itself, once per year. Being a market cap weighted index, it doesn't rebalance in a preset weighting way. In other words, if half the stocks in there fall in market cap, there the index is. That is the market cap weighting. Unless I'm wrong with this index. Same with TSM; if small caps are on a tear, then they make up a larger percentage of that index(it doesn't stay 72L, 18M, 10S.)

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Re: The problem with a 3 fund portfolio

Post by nedsaid » Thu Oct 10, 2013 6:51 pm

The three fund portfolio is a sound investment approach. Are there better ones? Probably. But I would argue this is vastly better than most.

The thing is that almost any investment approach can be shot full of holes by critics. If the approach cannot be shown to be bad then a critic could say that some other backtested approach would have done better. The question is, does it work and does it work well? And does it work the greatest majority of the time?

I would argue that all investment strategies fail. The best strategies fail only for short periods of time. Even broad diversification seems to fail in really bad markets. But most of the time, diversification does what it is supposed to do.

It would be hard for me to argue how a three fund portfolio would fail over long periods of time. You are getting the market returns for those markets. The point is that this approach works and works well.

Then one could argue over the proper asset allocation of the three fund portfolio.

These issues are fun to debate. But don't get drawn into either of two traps that snag a lot of investors. One is paralysis analysis. Never doing anything at all because of never being able to decide on a good investment approach. The other is constantly changing strategies which becomes a form of performance chasing. We all know how performance chasing works out. Not very well.

The important thing is to get started. Don't overthink this stuff. I am certainly not arguing for ignorance, but how can you learn if you don't get started?
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Re: The problem with a 3 fund portfolio

Post by JamesSFO » Thu Oct 10, 2013 7:19 pm

Dulocracy wrote:...
Yes and no. Let me show you an example of what I am thinking.

To make this easy, we are going to say we have a Total Fund that invests in imaginary lands. Call them Fanelia and Zaibach. The fund is 50% in Fanelia and 50% in Zaibach. Now, I have $100,000 in the fund. The shares owned in Zaibach are 1000 shares spread over 100 companies (easy numbers). The same goes for Fanelia shares. With me so far? The Zaibach part of the fund increases to $75,000 in value (with those 1000 shares in 100 companies), but the Fanelia portion reduces to $25,000.

Now, Zaibach shares are worth $75 per share (remember, the value changed, but the number of shares did not.) Fanelia shares dropped to $25 per share.

I need to take $10,000 out. I remove it from the Total Fund. The money comes proportionally, so $7,500 from Zaibach and $2,500 from Fanelia. Easy enough. Now, my $90,000 owned in Total Fund has 900 shares of Zaibach and 900 shares of Fanelia.

As the two do not always correlate, the world changes. Fanelia does well and Zaibach slips. Now Fanelia has shares worth $75 each and Zaibach has shares worth $25 each. In my Total Fund, I have $90,000. Even, correct?

My issue comes in at this point. If the funds were separate, you could have sold Zaibach shares when it was doing well to get the full $10,000 that you needed. This would result in owning $65,000 in Zaibach and $25,000 in Fanelia. You would have sold 133.33 shares from your Zaibach portion. You would then have 866.7 shares of Zaibach and 1000 of Fanelia. When the tables turned so that Fanelia was doing well, you would have $21,667.50 in Zaibach and $75,000 in Fanelia for a total of $96,667.5 in the portfolio. As it is separate, when you have to take the distribution again, you take it from Fanelia's Fund.

Yes, these are simple numbers for illustration purposes. The concept, however, is that having some separation allows you to sell the winners. Whether or not someone rebalances, my main point was that in distribution phase, a total fund could result in lower returns than separate funds. Substitute Fanelia and Zaibach with Asia/Europe or Small/Large or what have you, the argument I was trying to present is that because a Total Fund requires you to sell all at once, you could be forced to lock in losses when you need the money. Separating the money could help avoid this. That is my logic, and the reason that I posted asking for people with different views. How do proponents of the 3-fund view this? If there is an error in a premise, what is that error? I look forward to the responses.
So how do you decide how much to put in F & Z initially, and why? Further when you have future dollars to invest/withdraw what is your investment approach? Market cap? Losers?

Isn't your hypothetical about countries in Intl just a variation of saying instead of holding US Total stock you should hold components like Lg Cap, Mid Cap, and small cap separately?

And doesn't that just turtle all the way down? E.g. why not buy individual stocks because holding even a small cap mutual fund locks in your ability to harvest gains/losses?

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Re: The problem with a 3 fund portfolio

Post by crake » Thu Oct 10, 2013 7:56 pm

Dualacracy,

When you own an index funds it consists of many stocks. When you sell it some of them will be up and some of them will be down. Do you suggest that investors should own individual stocks instead of funds so that they don't have to sell the losers and "lock in losses"? If you don't suggest this why do you suggest doing it for countries or regions?

I believe the idea of "locking in losses" is a misnomer. When you buy a stock you paid what it was worth. When you sell a stock you get for it what it is worth. Aside from some potential tax considerations, the purchase price of a stock or fund should not influence your decision of whether or not you should sell it or buy more of it.

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Re: The problem with a 3 fund portfolio

Post by abuss368 » Thu Oct 10, 2013 8:15 pm

Way over thinking things here. The Three Fund Portfolio has many advantages and was Vanguard's expert recommendation for many years. They now recommend a Four Fund Portfolio with the addition of the Total International Bond Index.

Advantages
* low costs
* diversified
* no manager risk
* no style drift
* no fund or security overlap
* easy to rebalance
* easy to understand
* easy for heirs or spouse to manage
* tax efficient
* monthly and quarterly dividend income
* best of all - simplicity

I have relatives that invest in these three funds for many years and are so thankful for the simplicity and the results.

You may be able to do better but you can do a lot worse.

Remember there is more than one road to Rome.

Keep investing simple.
John C. Bogle - Two Fund Portfolio: Total Stock & Total Bond. "Simplicity is the master key to financial success."

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Re: The problem with a 3 fund portfolio

Post by baw703916 » Thu Oct 10, 2013 8:58 pm

nisiprius wrote: Are people really saying that a simple portfolio is best, but that it there isn't convincing evidence that anything else is better. Now this is a very different claim.
I think in some cases people are saying that simplicity should be an end in itself. As opposed to the goal being a good portfolio, which may end up being simple.
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Re: The problem with a 3 fund portfolio

Post by joe8d » Thu Oct 10, 2013 9:00 pm

abuss368 wrote:Way over thinking things here. The Three Fund Portfolio has many advantages and was Vanguard's expert recommendation for many years. They now recommend a Four Fund Portfolio with the addition of the Total International Bond Index.

Advantages
* low costs
* diversified
* no manager risk
* no style drift
* no fund or security overlap
* easy to rebalance
* easy to understand
* easy for heirs or spouse to manage
* tax efficient
* monthly and quarterly dividend income
* best of all - simplicity

I have relatives that invest in these three funds for many years and are so thankful for the simplicity and the results.

You may be able to do better but you can do a lot worse.

Remember there is more than one road to Rome.

Keep investing simple.
Yes and this can all be done with just a single TR or LS Fund which are,in effect," Total Portfolio" Funds.
Last edited by joe8d on Thu Oct 10, 2013 9:06 pm, edited 2 times in total.
All the Best, | Joe

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Re: The problem with a 3 fund portfolio

Post by abuss368 » Thu Oct 10, 2013 9:02 pm

joe8d wrote:
abuss368 wrote:Way over thinking things here. The Three Fund Portfolio has many advantages and was Vanguard's expert recommendation for many years. They now recommend a Four Fund Portfolio with the addition of the Total International Bond Index.

Advantages
* low costs
* diversified
* no manager risk
* no style drift
* no fund or security overlap
* easy to rebalance
* easy to understand
* easy for heirs or spouse to manage
* tax efficient
* monthly and quarterly dividend income
* best of all - simplicity

I have relatives that invest in these three funds for many years and are so thankful for the simplicity and the results.

You may be able to do better but you can do a lot worse.

Remember there is more than one road to Rome.

Keep investing simple.
Yes and this can all be done with just a single TR or LS Fund.

Exactly. Keep investing simple!
John C. Bogle - Two Fund Portfolio: Total Stock & Total Bond. "Simplicity is the master key to financial success."

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Re: The problem with a 3 fund portfolio

Post by FinancialDave » Thu Oct 10, 2013 9:21 pm

The important thing is to get started. Don't overthink this stuff. I am certainly not arguing for ignorance, but how can you learn if you don't get started?
+1
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Re: The problem with a 3 fund portfolio

Post by Dick D » Thu Oct 10, 2013 9:31 pm

I prefer doing other activities then spending a great amount of my time watching a number of funds. But if someone wants to go this, I say enjoy. I have more money that I need, but not as much time as I want.

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Re: The problem with a 3 fund portfolio

Post by zebrafish » Thu Oct 10, 2013 9:58 pm

What convinced me to pursue the 3-fund portfolio was looking at the Callan Periodic Table of Investment Returns-- there was always going to be an asset class outperforming another-- it is just that I cannot predict the future. The 3-fund approach is simple and elegant and I don't have to worry about tinkering and monitoring too many funds.

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Re: The problem with a 3 fund portfolio

Post by pkempfur » Thu Oct 10, 2013 11:11 pm

Dulocracy wrote: Yes and no. Let me show you an example of what I am thinking.

<snip>
My issue comes in at this point. If the funds were separate, you could have sold Zaibach shares when it was doing well to get the full $10,000 that you needed. This would result in owning $65,000 in Zaibach and $25,000 in Fanelia. You would have sold 133.33 shares from your Zaibach portion. You would then have 866.7 shares of Zaibach and 1000 of Fanelia. When the tables turned so that Fanelia was doing well, you would have $21,667.50 in Zaibach and $75,000 in Fanelia for a total of $96,667.5 in the portfolio. As it is separate, when you have to take the distribution again, you take it from Fanelia's Fund.

<snip>
This assumes that reversion to the mean happens within the timeframe you posit. Say Zaibach keeps going up 10% every year for 25 years and Fanelia keeps going down by 10% every year for the same 25 years. Or in the extreme case, say Fanelia goes bankrupt whereas Zaibach keeps growing. In such cases, (or unless your disbursement horizon exceeds 25 years) you'd be better off selling Fanelia first (thus cutting losses) and letting Zaibach grow (letting your winners run).

The point of using market-cap is that you have no assumptions of which way the market moves. If you do, then you have information that is unavailable to the market (and thus your advantage) or you are speculating.

FWIW, I do not use a 3 fund portfolio :) but hopefully I understand why it's used.

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Re: The problem with a 3 fund portfolio

Post by 2comma » Thu Oct 10, 2013 11:58 pm

Dulo,

I got the feeling from reading this thread that not many got your point; or maybe they did and I didn't. You did title your post "problem with 3 fund", that and "variable annuities for all" aren't received well around here; for good reason. The first point you made was about the withdrawal phase and if splitting up international into two regions might be a good strategy so that when you made withdrawals you could do it from the region that had fared better. You also asked for a discussion about the idea. I did not read that you were planing on doing any market timing between regions - just setting a market weight and taking distributions as needed. My first thought was that it was an interesting idea. I don't see anything inherently wrong with this notion. I certainly don't think, as was suggested, you were advocating doing this for every sub-class available - that argument is the slippery slope logical fallacy (but at least they were answering your question). Of course it might not be worth the effort when both regions perform about the same. It would add some complexity to your portfolio because you'd have one more thing to re-balance - but that could be mitigated by your drawdowns. So, if someone was willing to go to the effort I don't see any negatives. As Duckie says, something to think about...

I would like to know how often Europe and Asia have diverged in the past - it might not even be worth the effort.

With that said I do have a three fund portfolio and will be sticking to it for all of the reasons so often stated here.

As far as the psychological aspect of helping one stay the course I am doubtful. Frequently people that are new or risk averse are advised to go with an all-in-one or balanced fund to help shelter them from the ups and downs of their component parts. An experienced investor should already expect some things will be up and others down so actually seeing this in their portfolio would not sway them.
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Re: The problem with a 3 fund portfolio

Post by pascalwager » Fri Oct 11, 2013 12:07 am

TISM is a market capitalization fund, but you don't seem to be satisfied with the total int'l market concept. If you want to substitute separate Pacific and European funds to achieve a 50/50 balance, there is a rationale for doing so, discussed by Ferri and Bernstein. Other balances, such as 40/60, may be less defendable. Unfortunately the VG Pacific and European funds are much less diversified than TISM, but Ferri and Bernstein only use them in concert with other int'l funds (small cap, EM, etc.).

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Re: The problem with a 3 fund portfolio

Post by Dandy » Fri Oct 11, 2013 8:20 am

Simple is usually good for most investors, especially those not well versed in financial matters. I think the 3 fund is a bit too simple for most since it ignores a lot of fixed income options. Total Bond is a misleading title of the fund. If it was really a Total Bond fund then maybe the 3 fund portfolio would be more complete as well as simple.

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Re: The problem with a 3 fund portfolio

Post by Phineas J. Whoopee » Fri Oct 11, 2013 12:10 pm

Hi Dulocracy,

Thanks for starting this thread and posting your thoughts.

As you know, the form of reasoning you've used is induction. The difficulty I have is your reasoning does not lead to the conclusion you've drawn - that one should hold sections of the market separately. The conclusion it actually leads to is that one should hold individual stocks, because that would maximize the flexibility you're talking about. In fact, it leads to the conclusion one should hold all share classes of individual companies. I am not putting words into your mouth. That isn't what you said. But, unless my understanding is incorrect, that's the end result of your reasoning.

I can certainly see why somebody might want to do what you said, but I think your argument fails to support it.

Full disclosure: I personally use the three-fund concept (plus TIPS), but due to logistical issues across several accounts (each of which has its own reason for continuing to exist) there are, in a literal sense, more than four funds.

PJW

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Re: The problem with a 3 fund portfolio

Post by abuss368 » Fri Oct 11, 2013 12:23 pm

Individual Stocks - I fail to see that in the argument or conclusion.
John C. Bogle - Two Fund Portfolio: Total Stock & Total Bond. "Simplicity is the master key to financial success."

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Re: The problem with a 3 fund portfolio

Post by Phineas J. Whoopee » Fri Oct 11, 2013 12:28 pm

abuss368 wrote:Individual Stocks - I fail to see that in the argument or conclusion.
Phineas J. Whoopee wrote:... I am not putting words into your mouth. That isn't what you said. ...
PJW

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Re: The problem with a 3 fund portfolio

Post by JamesSFO » Fri Oct 11, 2013 1:25 pm

abuss368 wrote:Individual Stocks - I fail to see that in the argument or conclusion.
It's the logical conclusion, if picking countries as winners/losers is better, then why not pick large/small/medium within a country separately? Then why not pick individual stocks.

Put differently, why does the logic in the original post dictate AWAY from further breakdowns?

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Re: The problem with a 3 fund portfolio

Post by Dulocracy » Fri Oct 11, 2013 5:06 pm

ddj wrote: For the sake of argument, then, pretend that Fanelia is Japan in 1991 and Zaibach is, say, some other developed country. Can you stomach a lost decade or two (and does it behoove you to gradually sell off most of your Zaibach and wait and wait and wait for Fanelia to bounce back)? I couldn't; it doesn't.
That point is well made. Can the individual actually sit through a prolonged period of time with one portion of the portfolio in the dumps? If not, 3 fund would be much better. If they can stand it, it could be financially advantageous though, would it not?
MIpreRetirey wrote: The fund follows an index(FTSE global all-cap ex-US, in wiki) which is reviewed, itself, once per year. Being a market cap weighted index, it doesn't rebalance in a preset weighting way. In other words, if half the stocks in there fall in market cap, there the index is. That is the market cap weighting. Unless I'm wrong with this index. Same with TSM; if small caps are on a tear, then they make up a larger percentage of that index(it doesn't stay 72L, 18M, 10S.)
Agreed. It is important to note the difference between rebalancing to the market and rebalancing to the goal. If I have a goal of 50/50 and the market slides to 40/60, a total fund would also move to 40/60, whereas rebalancing would allow me to sell winners to buy those assets that are at a lower rate.

Unfortunately, I should not have brought in rebalancing, as it really is NOT my main point. I am talking about the distribution phase... where a loss is permanent when you cash in your shares. The idea being that, while a total fund goes up and down when the market goes up and down, you cannot sell the up parts and leave the down parts. You sell all parts.
nedsaid wrote:The three fund portfolio is a sound investment approach. ...

Agreed

I would argue that all investment strategies fail. The best strategies fail only for short periods of time. Even broad diversification seems to fail in really bad markets. But most of the time, diversification does what it is supposed to do.

It would be hard for me to argue how a three fund portfolio would fail over long periods of time. ...

This is the issue, though. I agree that 3 fund will work well over a long period of time. Distribution, however, is when you need it. If in my example, Zaibach is failing at a particular time, selling only Fanelia stocks would be better for the overall portfolio. That is, if one of the periods of failure is at distribution, it could cause havoc. If all of the world is in turmoil, you lose. If part of the world is doing ok, you can use that portion for the distribution. Of course you cannot predict if the bad-performing segment is going to recover in time, but you are giving it a chance by selling only the winners. In a total fund, you do not have this option.

\The important thing is to get started. Don't overthink this stuff. I am certainly not arguing for ignorance, but how can you learn if you don't get started?

Agreed. I have started. I am discussing this here to learn from people who know more than I do. I have a unique retirement situation with a wife that should live 20 years longer than I will (women outlive men by about 10 years, and I am 9 years older). I want to give her every opportunity to succeed, so I started, but I am also trying to learn by tossing ideas around to smart folk.
JamesSFO wrote:
So how do you decide how much to put in F & Z initially, and why? Further when you have future dollars to invest/withdraw what is your investment approach? Market cap? Losers?

How much to put in F & Z? Excellent question. In this scenario, I would say 50/50. Of course, that is basing it on the initial value. Obvious problems arise with that. Because my main point addresses the market at the time of distribution, perhaps use the 3 fund until distribution and then segregate on a dollar basis. Then, draw from the winner at that point? I think this is one of the more complex issues to resolve if one were to compartmentalize at the distribution phase.

Isn't your hypothetical about countries in Intl just a variation of saying instead of holding US Total stock you should hold components like Lg Cap, Mid Cap, and small cap separately?

I think that it is the same and different. Certainly, having those segments could also help under this theory, but a major regional difference (Asia vs. Europe) is a more significant part of my thought process here. Europe/Asia is more likely to be out of sync than Large/Small in one country.

And doesn't that just turtle all the way down? E.g. why not buy individual stocks because holding even a small cap mutual fund locks in your ability to harvest gains/losses?I am not arguing against mutual funds at all. I think that low cost investing with many assets is intelligent. Similarly, I could ask, why 3 fund instead of a 1 fund? Why not just have a 1 fund portfolio and be done with it (with your international, US, and bonds all in the same fund)? Because they act differently, correct? Otherwise, why not just find a target date fund that best fits and you have made it even more simple.
pkempfur wrote:
Dulocracy wrote: Yes and no. Let me show you an example of what I am thinking.

<snip>
My issue comes in at this point. If the funds were separate, you could have sold Zaibach shares when it was doing well to get the full $10,000 that you needed. This would result in owning $65,000 in Zaibach and $25,000 in Fanelia. You would have sold 133.33 shares from your Zaibach portion. You would then have 866.7 shares of Zaibach and 1000 of Fanelia. When the tables turned so that Fanelia was doing well, you would have $21,667.50 in Zaibach and $75,000 in Fanelia for a total of $96,667.5 in the portfolio. As it is separate, when you have to take the distribution again, you take it from Fanelia's Fund.

<snip>
This assumes that reversion to the mean happens within the timeframe you posit. Say Zaibach keeps going up 10% every year for 25 years and Fanelia keeps going down by 10% every year for the same 25 years. Or in the extreme case, say Fanelia goes bankrupt whereas Zaibach keeps growing. In such cases, (or unless your disbursement horizon exceeds 25 years) you'd be better off selling Fanelia first (thus cutting losses) and letting Zaibach grow (letting your winners run).

The point of using market-cap is that you have no assumptions of which way the market moves. If you do, then you have information that is unavailable to the market (and thus your advantage) or you are speculating.

FWIW, I do not use a 3 fund portfolio :) but hopefully I understand why it's used.
That is, I think, the strongest argument that I have heard so far in favor of 3 fund.
rickmerrill wrote:Dulo,

I got the feeling from reading this thread that not many got your point; or maybe they did and I didn't. You did title your post "problem with 3 fund", that and "variable annuities for all" aren't received well around here; for good reason. The first point you made was about the withdrawal phase and if splitting up international into two regions might be a good strategy so that when you made withdrawals you could do it from the region that had fared better. You also asked for a discussion about the idea. I did not read that you were planing on doing any market timing between regions - just setting a market weight and taking distributions as needed. My first thought was that it was an interesting idea. I don't see anything inherently wrong with this notion. I certainly don't think, as was suggested, you were advocating doing this for every sub-class available - that argument is the slippery slope logical fallacy (but at least they were answering your question). Of course it might not be worth the effort when both regions perform about the same. It would add some complexity to your portfolio because you'd have one more thing to re-balance - but that could be mitigated by your drawdowns. So, if someone was willing to go to the effort I don't see any negatives. As Duckie says, something to think about...

I would like to know how often Europe and Asia have diverged in the past - it might not even be worth the effort.

With that said I do have a three fund portfolio and will be sticking to it for all of the reasons so often stated here.

As far as the psychological aspect of helping one stay the course I am doubtful. Frequently people that are new or risk averse are advised to go with an all-in-one or balanced fund to help shelter them from the ups and downs of their component parts. An experienced investor should already expect some things will be up and others down so actually seeing this in their portfolio would not sway them.
Thank you for the insightful reply. Indeed, while I did mention other classes and divisions, my main point was whether or not there would be an advantage in separating Europe and Asia in the distribution phase. Next post, I will try to remember that simple is better (no pun intended).
pascalwager wrote:TISM is a market capitalization fund, but you don't seem to be satisfied with the total int'l market concept. If you want to substitute separate Pacific and European funds to achieve a 50/50 balance, there is a rationale for doing so, discussed by Ferri and Bernstein. Other balances, such as 40/60, may be less defendable. Unfortunately the VG Pacific and European funds are much less diversified than TISM, but Ferri and Bernstein only use them in concert with other int'l funds (small cap, EM, etc.).
Which is why my current allocation has 9 funds in it. I feel like I should not simply dismiss 3 fund without understanding it better. Asset Allocation is the main thing I joined this site to learn about, so I would be negligent if I did not explore this more. I am curious as to why 40/60 would be less defensible than 50/50 if the market weight is 40/60 when you start, so you use that as your base point.
Phineas J. Whoopee wrote:Hi Dulocracy,

Thanks for starting this thread and posting your thoughts.

As you know, the form of reasoning you've used is induction.

That is fair. If I had a definitive answer, I would write a book and get rich. Since I am trying to spark debate from which I can learn, I am giving a strong position and asking for responses.

The difficulty I have is your reasoning does not lead to the conclusion you've drawn - that one should hold sections of the market separately. The conclusion it actually leads to is that one should hold individual stocks, because that would maximize the flexibility you're talking about. ...

I disagree. I have neither the resources to do that in an effective manner, nor do I have the knowledge. As has been said, make things as simple as possible, but no simpler. Forgive me if my language was inartful, but in no way am I suggesting individual stock. I am suggesting adding a limited number of categories of funds would allow more flexibility in distribution. These funds would need to have different historical correlations, and they would be a breaking down of the funds used in 3-fund.
PJW
I thank everyone who has responded thus far, as it has given me a much better understanding of the logic behind a 3-fund. Pkempfur wins in most persuasive argument to me thus far. :sharebeer

Edited to fix a formatting error.
I'm not a financial professional. Post is info only & not legal advice. No attorney-client relationship exists with reader. Scrutinize my ideas as if you spoke with a guy at a bar. I may be wrong.

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Re: The problem with a 3 fund portfolio

Post by Phineas J. Whoopee » Fri Oct 11, 2013 5:29 pm

Dulocracy wrote:...
Phineas J. Whoopee wrote:Hi Dulocracy,

Thanks for starting this thread and posting your thoughts.

As you know, the form of reasoning you've used is induction.

That is fair. If I had a definitive answer, I would write a book and get rich. Since I am trying to spark debate from which I can learn, I am giving a strong position and asking for responses.

The difficulty I have is your reasoning does not lead to the conclusion you've drawn - that one should hold sections of the market separately. The conclusion it actually leads to is that one should hold individual stocks, because that would maximize the flexibility you're talking about. ...

I disagree. I have neither the resources to do that in an effective manner, nor do I have the knowledge. As has been said, make things as simple as possible, but no simpler. Forgive me if my language was inartful, but in no way am I suggesting individual stock. I am suggesting adding a limited number of categories of funds would allow more flexibility in distribution. These funds would need to have different historical correlations, and they would be a breaking down of the funds used in 3-fund.
PJW
I thank everyone who has responded thus far, as it has given me a much better understanding of the logic behind a 3-fund. Pkempfur wins in most persuasive argument to me thus far. :sharebeer

Edited to fix a formatting error.
Thank you for your reasonable response.

Agreement or disagreement doesn't enter into it. I was extraordinarily careful to say you did not claim owning individual stocks, even distributed over the whole world in their market-cap proportions, was the right thing to do.

My point was, is, and is only, that you framed your OP in terms of premises and a conclusion, and that your conclusion did not follow from your premises.

With respect to an individual attempting to hold a cap-weighted whole-world equity portfolio, company by company and share class by share class, I agree it is impractical.

Again, I hope I was clear. I said you didn't mean to suggest it. I only said your reasoning leads to it.

And, in a spirit of goodwill, I return your genuine celebratory conclusion:
:sharebeer
PJW

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Re: The problem with a 3 fund portfolio

Post by MIretired » Fri Oct 11, 2013 5:46 pm

MIpreRetirey wrote:
The fund follows an index(FTSE global all-cap ex-US, in wiki) which is reviewed, itself, once per year. Being a market cap weighted index, it doesn't rebalance in a preset weighting way. In other words, if half the stocks in there fall in market cap, there the index is. That is the market cap weighting. Unless I'm wrong with this index. Same with TSM; if small caps are on a tear, then they make up a larger percentage of that index(it doesn't stay 72L, 18M, 10S.)

Dulocracy wrote "

Agreed. It is important to note the difference between rebalancing to the market and rebalancing to the goal. If I have a goal of 50/50 and the market slides to 40/60, a total fund would also move to 40/60, whereas rebalancing would allow me to sell winners to buy those assets that are at a lower rate.

Unfortunately, I should not have brought in rebalancing, as it really is NOT my main point. I am talking about the distribution phase... where a loss is permanent when you cash in your shares. The idea being that, while a total fund goes up and down when the market goes up and down, you cannot sell the up parts and leave the down parts. You sell all parts.
I didn't put down all I had thought.
The withdrawal phase of investing with the 3-fund port. is not so much as it might seem about selling winners-not losers. I find a more enticing reason to separate regions for the sake of out-performers.
But,if Tot.Intern. holds 55% EUR, 30% PAC,and 15% EM regions, your sale would be that ratio. If somehow EM and PAC fell 50%, and EUR region stayed steady, Tot. Intern. would be 71% EUR, and you'd be selling more of those. Plus you're not timing as much. What if EUR region continues to out-perform.
I might be inclined to only own DEV. Market, and leave EM because of possible out-performance, though.
But, the total fund takes a lot of the emotion out of it, which is good.

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Re: The problem with a 3 fund portfolio

Post by Phineas J. Whoopee » Fri Oct 11, 2013 5:49 pm

MIpreRetirey wrote:
MIpreRetirey wrote:
The fund follows an index(FTSE global all-cap ex-US, in wiki) which is reviewed, itself, once per year. Being a market cap weighted index, it doesn't rebalance in a preset weighting way. In other words, if half the stocks in there fall in market cap, there the index is. That is the market cap weighting. Unless I'm wrong with this index. Same with TSM; if small caps are on a tear, then they make up a larger percentage of that index(it doesn't stay 72L, 18M, 10S.)

Dulocracy wrote "

Agreed. It is important to note the difference between rebalancing to the market and rebalancing to the goal. If I have a goal of 50/50 and the market slides to 40/60, a total fund would also move to 40/60, whereas rebalancing would allow me to sell winners to buy those assets that are at a lower rate.

Unfortunately, I should not have brought in rebalancing, as it really is NOT my main point. I am talking about the distribution phase... where a loss is permanent when you cash in your shares. The idea being that, while a total fund goes up and down when the market goes up and down, you cannot sell the up parts and leave the down parts. You sell all parts.
I didn't put down all I had thought.
The withdrawal phase of investing with the 3-fund port. is not so much as it might seem about selling winners-not losers. I find a more enticing reason to separate regions for the sake of out-performers.
But,if Tot.Intern. holds 55% EUR, 30% PAC,and 15% EM regions, your sale would be that ratio. If somehow EM and PAC fell 50%, and EUR region stayed steady, Tot. Intern. would be 71% EUR, and you'd be selling more of those. Plus you're not timing as much. What if EUR region continues to out-perform.
I'd might be inclined to only own DEV. Market, and leave EM because of possible out-performance, though.
But, the total fund takes a lot of the emotion out of it, which is good.
If you wish to hold a total-market portfolio then hold one: buy it; sell it; it all works out the same.

If you don't wish to then structure your portfolio otherwise.

It isn't clear to me why there is misunderstanding on this point.

PJW

MIretired
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Re: The problem with a 3 fund portfolio

Post by MIretired » Fri Oct 11, 2013 6:04 pm

No misunderstanding. And anyone can do what they prefer. But I think that there are a lot of people that think that total funds rebalance like funds of funds. That was people's assumption, and an easy one to make. Just for anyone else reading.

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Phineas J. Whoopee
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Re: The problem with a 3 fund portfolio

Post by Phineas J. Whoopee » Fri Oct 11, 2013 6:20 pm

MIpreRetirey wrote:No misunderstanding. And anyone can do what they prefer. But I think that there are a lot of people that think that total funds rebalance like funds of funds. That was people's assumption, and an easy one to make. Just for anyone else reading.
Fair enough, but if I may, total-market funds-of-funds don't need to rebalance any more than total-market funds do.

A mutual fund is nothing more than a vehicle by which to hold underlying assets. All of the returns come from the underlying assets. There's nowhere else for them to come from. If the underlying assets are the same, how can the result not be the same, excepting the drag of extra turnover between constituent sub-funds?

If an investor consciously chooses not to replicate the total market, then that's a different issue.

PJW

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Riceman
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Re: The problem with a 3 fund portfolio

Post by Riceman » Fri Oct 11, 2013 10:32 pm

I agree with OP. Simple is worse for taxable accounts if you are in a position to harvest losses, but especially if you are in a position to harvest gains. I am 15 percent tax bracket, so 0 long term gains. Individual stocks would be the best for me, harvesting gains some years and losses the others. B
ut since this is too much work, i plan to do the same thing with 6or7 mutual funds that aren't as highly correlated.

Note that the reason for this strategy is not beating the market, which i agree is impossible. It is beating the taxman, which is the one area where financial advisors/knowledgeable investors shine.

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Re: The problem with a 3 fund portfolio

Post by MIretired » Fri Oct 11, 2013 10:59 pm

PJW,

Yep, got it. Only funds of funds which specify a % or %range per fund. As a target date fund or life strategy fund. VGTSX used to be VEURX,VPACX,VEIEX( I think it was these), and had sort of a mandate of percentages each- sort of -a range or something.

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Re: The problem with a 3 fund portfolio

Post by pkcrafter » Fri Oct 11, 2013 11:32 pm

Dulo wrote:
1) The first problem is that it is too simple.
First of all, there is elegance in simplicity, and it's hard to argue that a 3-fund portfolio is too simple. You have total U.S., total international, and total bond, which gives you very broad global coverage. Any attempt to slice more is an attempt to outperform the markets. Additionally, as we age, simplicity is much easier to manage.
Sometimes, because humans are weird, it may not be best for all people. Simple works better for my wife, for example.
Not sure if you mean your wife would be happy with a 3-fund portfolio or she would prefer a TR or LS single fund? Anyway, it's a fair point and there are many investors who just prefer a simple approach. Certainly, a slice/dice portfolio requires more work.
2) The second point is not that 3-fund is inappropriate for all people, but it is for some on the following grounds: The oversimplification can cause a psychological problem with maintaining a portfolio. That is, if the total stock market is down, someone may panic and sell. If one portion is down, but another is not, it is more likely to remind people that part of the portfolio is acting differently than the rest. It is easier to stomach a crash in 20% of a portfolio than in 50%.
Portfolio losses are mostly determined by AA. A 20% loss might result from a portfolio containing 40% stock. A 50% loss might result from a 100% stock allocation. Any psychological behavior problem will result from total losses and any portfolio from the simple 3 to a complex 10 fund portfolio will likely cause panic if the investor is not emotionally prepared.

As far as locking in losses, investors should not withdraw from stocks in a market downturn. Secondly, in a severe drawdown, all correlations tend to approach 1, and asset classes with higher volatility, EM for instance, will have deeper losses. That would suggest holding individual asset classes may be harder to do. Also hard to argue that new, inexperienced investors should start out with complex portfolios.

Paul
When times are good, investors tend to forget about risk and focus on opportunity. When times are bad, investors tend to forget about opportunity and focus on risk.

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JamesSFO
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Re: The problem with a 3 fund portfolio

Post by JamesSFO » Sat Oct 12, 2013 8:17 am

Dulocracy wrote:...
Phineas J. Whoopee wrote:Hi Dulocracy,

Thanks for starting this thread and posting your thoughts.

As you know, the form of reasoning you've used is induction.

That is fair. If I had a definitive answer, I would write a book and get rich. Since I am trying to spark debate from which I can learn, I am giving a strong position and asking for responses.

The difficulty I have is your reasoning does not lead to the conclusion you've drawn - that one should hold sections of the market separately. The conclusion it actually leads to is that one should hold individual stocks, because that would maximize the flexibility you're talking about. ...

I disagree. I have neither the resources to do that in an effective manner, nor do I have the knowledge. As has been said, make things as simple as possible, but no simpler. Forgive me if my language was inartful, but in no way am I suggesting individual stock. I am suggesting adding a limited number of categories of funds would allow more flexibility in distribution. These funds would need to have different historical correlations, and they would be a breaking down of the funds used in 3-fund.
PJW
I thank everyone who has responded thus far, as it has given me a much better understanding of the logic behind a 3-fund. Pkempfur wins in most persuasive argument to me thus far. :sharebeer

Edited to fix a formatting error.
I'm still not seeing why your logic stops at picking country funds? If picking region/country funds is somehow simple enough but individual stocks is too hard, why not at least break apart based on available style funds, e.g. small/mid/large cap or value/growth at a minimum, since that would only be order of magnitude 20-30 funds but would better allow you to tax harvest?

Also even if you are just picking region mutual funds (europe, asia, emerging markets, etc), you've never explained during the accumulation phase how you simply decide how to get the money into those funds? It's strikes me as potentially hard for the average person to manually cap weight purchases of the different region mutual funds, or are you proposing just equal weighting of the different countries during accumulation? If so, why?

I think you've picked the straw man of the withdrawal phase and (1) decided arbitrarily what's simple/hard and (2) omitted the complexity of the accumulation phase and allocations.

Is the 3-fund (or 4 fund) portfolio perfect? No, but it is pretty darn good for helping people capture the market return cost effectively and without having to spend much time on the problem.

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Re: The problem with a 3 fund portfolio

Post by less » Sat Oct 12, 2013 9:21 am

crake wrote:Do you suggest that investors should own individual stocks instead of funds so that they don't have to sell the losers and "lock in losses"?
I agree. The OPs arguments all come down to his belief that there is some great bonus from rebalancing. Don't agree that that is a fact. And if you accept that a greater splitting of funds allows for greater rebalancing, then you would have to also agree that holding individual stocks would maximize that process.

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Re: The problem with a 3 fund portfolio

Post by letsgobobby » Sat Oct 12, 2013 9:30 am

Dulocracy wrote:Let me begin by saying that I am in no way an expert, so I welcome experts to argue these points. I want to know if I am wrong. However, there are two problems with a 3 fund portfolio that I see.

1) The first problem is that it is too simple. That expression about keeping things as simple as they can be, but not more simple? That applies here from what I see. Here is why: If I have Total Bond, Total Stock Market, and Total International, regional fluctuations cannot be separated from the fund. That is: If Europe starts doing really well, but Asia crashes, all of my money is in one fund that has both. This is only a problem under two circumstances, but it is a big problem if either applies. This almost seems like an argument against indexing itself. If Asia crashes, that means all investors think Asia is worth less. If you wanted to hold more Asia than investors thought was correct, wouldn't you be actively managing and not indexing? The only reason I don't follow market weights with regards to US vs international is because I have large fixed costs in US dollars and the US economy. If I were an intrepid global traveler I would definitely just hold a total world stock index, market cap weighted, without attempting to outguess market wisdom.

1) A) Circumstance 1 is the disbursement phase of life. If I have all of my international holdings in Total International, taking money out may lock in losses. If Europe is doing well and Asia is not, selling this fund will lock in losses in Asia. If Asia is doing well, but Europe is not- selling locks in losses in Europe. Only if both Asia and Europe are doing well is this a good fund to sell. I would rather be able to have a separate fund for Europe and one for Asia. That way, if Europe is doing well, I can rebalance by cashing in the European fund while it is doing well. This way, I am always taking from the winners while rebalancing. In a Total International fund, this is not possible. Yes, one would lose out on the 10% of the fund that is in Africa, Canada, South America, and whatnot, but that could either be resolved by getting a couple of small holdings in said funds or ignoring those regions in order to be able to have money in a format more flexible (that does not force locked-in losses). I think this is a valid point but I don't think it will be significant in actual dollars. Furthermore, as others have pointed out, you could extend your logic to owning each individual region separately, but also each individual country separately, each individual sector separately, and finally each individual stock separately. In fact a few posters to this forum have argued just that over the years: that a group of 20-100 individual stocks accomplishes the same goals as indexing, but with greater tax efficiencies (tax loss harvesting opportunities), more control, and lower fees. Yet most of us still choose to index - it has a proven track record, it's very easy/simple, and the dollars potentially saved by switching from a 0.05% ER index to a 0.02% self-managed basket of stocks simply isn't enough to make the effort worthwhile.

1) B) Which leads to rebalancing. If I want to have 40% Asia and 60% Europe, I cannot control that in Total International. If someone asks why the proportion is important? I would ask why it is important to assign to total international vs. total US. As economic regions, Europe and Asia perform very differently. I am not arguing to the absurd of going so far as to have a fund for Norway and a different one for Sweden, but major economic groupings seem like they would best be given a portion and kept separately best allow for rebalancing to goal. Answered above.

2) The second point is not that 3-fund is inappropriate for all people, but it is for some on the following grounds: The oversimplification can cause a psychological problem with maintaining a portfolio. That is, if the total stock market is down, someone may panic and sell. If one portion is down, but another is not, it is more likely to remind people that part of the portfolio is acting differently than the rest. It is easier to stomach a crash in 20% of a portfolio than in 50%. Personally, I will look for which fund is doing the worst in order to add a couple of hundred dollars. This is not to say that the money actually matters, but the symbolism of the action reminds me to stay the course. It is a reminder to buy low, sell high, and that the market will likely recover. This is NOT to say that one market times (notice it is only a few hundred that I put in for the symbolism). The point is that a 3 fund portfolio may cause some to panic out of whatever third of their portfolio is crashing right when they would lock in the worst losses. Psychologically, having multiple funds would allow the person to look at the portfolio more as a unit with parts that move independently of each other and work together in the end rather than as a single hot potato that will burn more if they hold it longer. On this point I stridently disagree. What is more likely to happen is that when a portion of a portfolio is sharply lower, investors will sell it - not buy it. This is what I expect to happen on average, of course you may be different. Similarly target date funds are an ideal solution for many investors - there are no component parts of a portfolio to fiddle with, or to sell low or buy high. Some data suggest that target date fund investors are stickier than other investors - more likely to buy and hold for the long run, which seems to support the idea that the simpler a portfolio is, the more likely an investor is to not try to fix what's not broken.

In summary, the main problems that I see with a 3 fund portfolio are that it can force someone who is taking distributions to lock in losses, and it can work against the psychology of some investors.

Your thoughts? (This is what makes this actionable. In full disclosure, while Ferri and Swedroe sometimes butt heads, my investment strategy evolved from a lot that I have read in their books. I currently have 9 fund categories in my asset allocation. I will be watching the comments here to evaluate my understandings that underlie the method by which I picked a portfolio asset allocation.)

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Re: The problem with a 3 fund portfolio

Post by bottlecap » Sat Oct 12, 2013 12:10 pm

The answers are these:

1) Any "advantage" to being able to "rebalance" or selectively withdraw between regions in an asset class is miniscule and not worth the added complexity to most people. If you want complex, that's fine, eek out an extra basis point or three. On average, however, history shows the difference is not great. Mmost people don't care to think that much about there investments.

2) This is an unsupported statement of opinion, so there's no sense in addressing it. It can be debated, but short of a some sort of study or unassailable logic behind it, there's no way to demonstrate it.

In the end, it's not a question of whether the 3 fund can be beat - it can. It's a question of how likely it is to be beaten, even assuming perfect execution in attending to the alternative portfolio, and a question of how much extra return you will get compared to the effort put in. With all the important things that determine a successful financial plan, having additional funds over the 3 fund portfolio is way, way down on the list.

JT

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Re: The problem with a 3 fund portfolio

Post by ogd » Sat Oct 12, 2013 3:05 pm

Two points:

1) Selective withdrawals are a bit of a red herring and reduce to rebalancing in the absence of tax considerations. Withdrawing from B in preference to A to bring them to a set proportion is equivalent to selling both and rebalancing. Yes, taxes are important and the whole reason why I have a much more complicated portfolio, with munis and separation of stocks & bonds. If I were fully tax-advantaged, I'd probably be in LifeStrategy Moderate Growth and not give it another thought. The taxation caveat is very well documented on this board.

2) Which brings us to rebalancing / setting proportions. There are asset classes for which this makes a lot of sense to me -- the ones that are "special enough". For example, bonds serve to reduce volatility and put a floor on portfolio losses; US stocks earn in the same currency that my bills are denominated in (and still, I just "overweigh" them rather than a fixed proportion). Beyond that, I'd be just second guessing the market if I put any number on a region or size divide. Who am I to say that Europe will continue to be 20% (or whatever) of the world's market? Maybe the business conditions will deteriorate there on a permanent basis. Same for small stocks: who's to say that there won't be a permanent qualitative change in economies of scale due to some technological factor, for example, placing a permanent advantage on being large. To me it's no different than fixing the proportions of Apple and Samsung in my portfolio, on the assumption that whatever changes occur in relative market share of these two will mean-revert and one can extract a rebalancing bonus from all the zig-zagging. Such an assumption seems entirely unwarranted.

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Re: The problem with a 3 fund portfolio

Post by tpm871 » Sat Oct 12, 2013 4:36 pm

I agree with the OP, although I'd say that slice & dice isn't for everyone. If you don't want to spend a bit more time, don't have the risk tolerance to rebalance when it feels uncomfortable, and/or selling to rebalance puts you at a tax disadvantage (e.g., not much room in tax deferred space, not much capital losses to offset gains, high tax bracket) then the three fund approach may be better for you.

With that said, I think I'm better off splitting among Europe, Pacific Rim, and Emerging Markets rather than just Total International. Here's some things to consider:

1. Fees are actually a little lower if you invest in Europe and Pacific Rim separately: 0.16 ER for VXUS vs. only 0.12 ER for VGK and VPL.

2. As the OP suggested, investing in different funds with independent risk factors gives you more opportunities to buy low / sell high at times. For example, if there's a temporary dip in Europe that causes that fund to fall below its allocation, then you'd be able buy just that fund at a discount in comparison to Asia.

3. "Rebalancing" doesn't necessarily require selling. For example, if you direct new contributions and/or dividends towards your fund(s) that are furthest below their allocation, you'd be adjusting the balance without selling or paying taxes.

4. Market weight isn't a guarantee that it's the best weighting. Just because Europe is X% and Asia is Y% of the world market doesn't mean that's automatically best for you. It just means that you don't have to sell or buy more shares of Total International to stay at market weight. Total International doesn't rebalance by taking advantage of opportunties to buy low / sell high; it's just always at market weight by definition.

5. Different people may want to take more or less risk by tilting differently among different regions, and they'd achieve higher or lower returns as a result. Just as you choose how much to put in equities vs. bonds according to your risk tolerance, I think it's fine to choose a non-market weighting of regions according to your risk tolerance (e.g., overweighting or underweighting emerging markets).

As long as you have the risk tolerance for separate funds, and it doesn't cost you in taxes more than you're likely to gain, then I think investing in separate funds is likely to do better due to a rebalancing bonus. That is, if you have the discipline.

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Re: The problem with a 3 fund portfolio

Post by ogd » Sat Oct 12, 2013 4:59 pm

tpm871 wrote:4. Market weight isn't a guarantee that it's the best weighting. Just because Europe is X% and Asia is Y% of the world market doesn't mean that's automatically best for you.
What is the best weighing for me, then? I don't really care about either, since I live in the US. Where would I come up with X and Y? Why would I want to ignore the possibility of seismic shifts in the distribution of global wealth, and insist that Europe has to be 20% despite all the indicators that the market is looking at? The 40% fixed income in my portfolio represents my risk tolerance, but what is Y%? My Asia tolerance?

This strikes me as cargo cult investing. We notice that having a % in fixed income and rebalancing to it is a good idea, then we blindly apply the same method to any slices of any market that have a reasonable chance of diverging, without asking ourselves why. This is despite observing that sectoral balances and regional balances shift permanently all the time.
tpm871 wrote:5. Different people may want to take more or less risk by tilting differently among different regions, and they'd achieve higher or lower returns as a result. Just as you choose how much to put in equities vs. bonds according to your risk tolerance, I think it's fine to choose a non-market weighting of regions according to your risk tolerance (e.g., overweighting or underweighting emerging markets).
So what is more risky and more return-y, then, going forward? Asia or Europe? Care to elaborate on why? Emerging is the one asset that I can see having an argument for, and it has been more volatile in the past, but will it be so in the future? Also, which region has the best risk-adjusted returns? And more importantly, why do I need to make these judgment calls, above and beyond the market's, which have nothing to do with my personal situation? I just don't get it. I might as well go pick individual stocks, or shift back and forth between consumer discretionary and consumer staples like CNBC is recommending all the time.

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