Please Help me understand 3-fund portfolio

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thethinker
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Please Help me understand 3-fund portfolio

Post by thethinker » Wed Apr 16, 2014 7:24 am

I have done reading on this forum about the success of a 3 fund portfolio for long term investing, but I was hoping some people here could help me understand the reason for the success.

The three funds I am looking at are:
Vanguard Total Stock Market Index Fund Admiral (VTSAX)
Vanguard Total Bond Market Index Fund Admiral (VBTLX)
Vanguard Total International Stock Index Fund Admiral (VTIAX)

I have a chart which shows how money invested in each of these would have grown over the last decade (all on the same chart), but I don't know how to post images so if someone else has info like this, please post below.


To my original reason for this post, I am trying to understand the basic reason for a 3 fund portfolio. Do people use the 3 fund portfolio because two funds (listed above) are expected to increase if one fund were to fall (for example, if the US Stock Market drops by 30%, do people expect the Bond Fund & International Funds to improve in value?). Or is this simply a case of keeping all your eggs out of one basket (Example, the US Stock Market drops 30%, the International drops 15% and the Bond Market stays the same), so the total value of your portfolio would not drop 30%, as it would if you had fully invested in US Stocks (example above)?

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Re: Please Help me understand 3-fund portfolio

Post by dbr » Wed Apr 16, 2014 7:31 am

thethinker wrote:

To my original reason for this post, I am trying to understand the basic reason for a 3 fund portfolio. Do people use the 3 fund portfolio because two funds (listed above) are expected to increase if one fund were to fall (for example, if the US Stock Market drops by 30%, do people expect the Bond Fund & International Funds to improve in value?). Or is this simply a case of keeping all your eggs out of one basket (Example, the US Stock Market drops 30%, the International drops 15% and the Bond Market stays the same), so the total value of your portfolio would not drop 30%, as it would if you had fully invested in US Stocks (example above)?
That is exactly it. You are diversified across the dimension of US vs outside US, and the volatility of stocks is diluted by holding something in bonds. The second of these is by far the most important consideration.

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Re: Please Help me understand 3-fund portfolio

Post by thethinker » Wed Apr 16, 2014 8:49 am

dbr wrote:
thethinker wrote:

To my original reason for this post, I am trying to understand the basic reason for a 3 fund portfolio. Do people use the 3 fund portfolio because two funds (listed above) are expected to increase if one fund were to fall (for example, if the US Stock Market drops by 30%, do people expect the Bond Fund & International Funds to improve in value?). Or is this simply a case of keeping all your eggs out of one basket (Example, the US Stock Market drops 30%, the International drops 15% and the Bond Market stays the same), so the total value of your portfolio would not drop 30%, as it would if you had fully invested in US Stocks (example above)?
That is exactly it. You are diversified across the dimension of US vs outside US, and the volatility of stocks is diluted by holding something in bonds. The second of these is by far the most important consideration.

I thought of this as an either/or question not 'both'. If you don't mind a follow up, may I ask it this way:

do people A) use the 3 fund portfolio because two funds (listed above) are expected to increase if one fund were to fall (for example, if the US Stock Market drops by 30%, do people expect the Bond Fund & International Funds to improve in value?).
or B) is this simply a case of keeping all your eggs out of one basket (Example, the US Stock Market drops 30%, the International drops 15% and the Bond Market stays the same), so the total value of your portfolio would not drop 30%, as it would if you had fully invested in US Stocks (example above)?

I am not sure how it can be both, thought maybe it is and if so would you mind explaining that in a bit more detail please. thank you for sending a reply.

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Re: Please Help me understand 3-fund portfolio

Post by Rick Ferri » Wed Apr 16, 2014 8:58 am

There are two asset classes and three funds in the 3-fund portfolio. The asset classes are stocks and bonds. Within the stock asset class there are US stocks and international stocks, which are mutually exclusive.

The bond/stock mix of a portfolio controls it's risk level. This is the most important part of any portfolio whether it is three funds or the funds. The split between US stocks and international stocks add a little more diversification to the stock side due to differ currency exposures.

The US versus international stock allocation has about one-fifth (or less) the importance as the bond versus stock allocation.

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Re: Please Help me understand 3-fund portfolio

Post by YDNAL » Wed Apr 16, 2014 9:18 am

thethinker » Wed Apr 16, 2014 10:49 am

I thought of this as an either/or question not 'both'. If you don't mind a follow up, may I ask it this way:

do people A) use the 3 fund portfolio because two funds (listed above) are expected to increase if one fund were to fall (for example, if the US Stock Market drops by 30%, do people expect the Bond Fund & International Funds to improve in value?).
or B) is this simply a case of keeping all your eggs out of one basket (Example, the US Stock Market drops 30%, the International drops 15% and the Bond Market stays the same), so the total value of your portfolio would not drop 30%, as it would if you had fully invested in US Stocks (example above)?

I am not sure how it can be both, thought maybe it is and if so would you mind explaining that in a bit more detail please. thank you for sending a reply.
Both.

A) By diversifying amongst the US Stock Market and non-US (Europe, Far East, etc.), each of these Regions can behave differently under different circumstances. That said, *behavior* is not guaranteed, and they can behave exactly the same way at any time and during any length of time. This is called correlation - which is fluid and non-static.
http://www.investopedia.com/terms/c/cor ... icient.asp

B) Bonds are a different Asset Class that should be included to mitigate the risks in (A) above and should largely behave (*correlate*) differently.
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Re: Please Help me understand the 3-fund portfolio

Post by nisiprius » Wed Apr 16, 2014 9:59 am

thethinker wrote:To my original reason for this post, I am trying to understand the basic reason for a 3 fund portfolio. Do people use the 3 fund portfolio because two funds (listed above) are expected to increase if one fund were to fall (for example, if the US Stock Market drops by 30%, do people expect the Bond Fund & International Funds to improve in value?). Or is this simply a case of keeping all your eggs out of one basket (Example, the US Stock Market drops 30%, the International drops 15% and the Bond Market stays the same), so the total value of your portfolio would not drop 30%, as it would if you had fully invested in US Stocks (example above)?
It's much simpler and, alas, less magic than that. I'm probably going to catch flack for saying this, but "diversification" is oversold. If you read the fine print you will always see a disclaimer like this: "Diversification does not ensure a profit or protect against a loss."

Image

If there were really an investment that earned a good return and consistently moved in the opposite direction as the stock market, that would mean you could use it to cancel out the volatility of the stock market. That would mean you could get the stock market's return without the risk. That's too good to be true--a free lunch. The more sophisticated idea is your second idea. Thus, for example, historically stocks and bonds have zero correlation. That means when stocks go up, bonds sometimes go up and sometimes go down; when stocks go down, bonds sometimes go down and sometimes go up. Overall, on a numerical calculation basis, that means that the combination has a somewhat less risk in relation to its return than the sum of its parts.

But that's not the reason for a three-fund portfolio. In a three-fund portfolio, the bond component is a conservative, total bond index fund that is not very volatile, and doesn't do a very powerful job of canceling out stock risk. It just manages risk in a plain vanilla, dumb way, the same way cash would: by diluting it. And by diluting or reducing return at the same time, of course.

It just has to do with matching the risk and return to your personal tastes and needs. The reasons for a three-fund portfolio can be laid out as follows:

The three basic asset classes are stocks, bonds, and cash. (I think all the blather about other asset classes is mostly nonsense: novelty, fashion trends, and people trying to sell stuff). It is appropriate for most investors to hold some of each.

Blue: stocks. Orange: bonds. Green: cash.

Image

For most retirement savers, 100% stocks is inappropriate because it has too much risk = volatility = fluctuation. Bonds are much less volatile than stocks and are very effective at diluting stock risk. Not opposing it, not canceling it out, just diluting it. You could do the same thing with cash, but bonds earn meaningfully more. You might be upset if you held a bond fund instead of a bank account and put in $10,000 one day and saw $9,500 six months later, because in a bank account we don't expect to see the numbers go down, ever. But, if you are holding stocks, the fluctuations from the stocks are so much bigger than bonds that the fluctuations in the bonds hardly matter, while the extra return from the bonds does matter.

Within each of the asset classes, stocks and bonds, there is a very strong case to be made for using a broadly diversified mutual fund with hundreds or thousands of individual stocks and bonds in it. The risk of individual stocks is much higher than that of an index fund. Even the risk of five or ten stocks is higher. And investing theory suggests that this is unrewarded risk, that the market "does not reward risk that can be diversified away." Here, diversification is meaningful in terms of risk reduction. Twenty years ago, if you'd invested in Apple, you'd have done far better than if you just stuck with Total Stock. But if you picked Citigroup, you'd have done far worse. So yes, you really are reducing the risk by investing in an index fund. You still get the very significant risk of the stock market as a whole.

Image

So think of it as a stepwise process. How much risk is appropriate for me? What mix of basic asset classes, stocks, bonds, cash, and crazy stuff (my opinion) do I want to hold to achieve that risk? And, what should I use as a way of investing in each asset class?

The three-fund portfolio is basically an appeal to simplicity. If you cut it down to essentials, you say "I need stocks. I need bonds. I will use Vanguard Total Stock Market Index for stocks. I will use Vanguard Total Bond Market Index for bonds. I need to be that complicated because I need both stocks and bonds--bonds, to return more than cash, but dilute the risks of stocks. Beyond that, it is hard to prove anything is better, so I will go with I know is cheap and simple."

In John C. Bogle's words:
Pillar 2. When All Else Fails, Fall Back on Simplicity.

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.
You might notice I haven't mentioned international. A dictum, "Make things as simple as possible, but not simpler," is sometimes attributed to Einstein (but is probably a paraphrase). Many people end up thinking that U.S. stock index + U.S. bond index is maybe a bit too simple. The commonest complication is adding international stocks. Vanguard currently is up to four, because they add international bonds as well.

The question of international stocks is always a topic of spirited discussion in this forum, and the reason is precisely that based on past history it hasn't really made much difference. It has not been a powerful diversifier. I hold it basically for the same reason I hold Total Stock instead of 500 Index. It's not that I really think the small caps in Total Stock matter much, but Total Stock doesn't cost any more and currently it is less opinionated to hold it. By the same token, I hold some Total International stock fund because I'm chicken to stray too far from the mainstream conventional wisdom, and 100% U.S. would be too opinionated.
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Nisiprius answers a question.

Post by Taylor Larimore » Wed Apr 16, 2014 10:10 am

I am trying to understand the basic reason for a 3 fund portfolio.
thethinker:

I am glad I did not answer your question. Nisiprius has answered it much better than I could.

Best wishes.
Taylor
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Re: Please Help me understand 3-fund portfolio

Post by Rick Ferri » Wed Apr 16, 2014 10:31 am

Diversification reduces the risk of a large loss.

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Re: Nisiprius answers a question.

Post by thethinker » Wed Apr 16, 2014 10:44 am

thank you to everyone who made a post, this has been great information and I am learning lots.

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Re: Please Help me understand 3-fund portfolio

Post by CyberBob » Wed Apr 16, 2014 10:50 am

Rick Ferri wrote:There are two asset classes and three funds in the 3-fund portfolio. The asset classes are stocks and bonds. Within the stock asset class there are US stocks and international stocks, which are mutually exclusive.

The bond/stock mix of a portfolio controls it's risk level. This is the most important part of any portfolio whether it is three funds or the funds. The split between US stocks and international stocks add a little more diversification to the stock side due to differ currency exposures.

The US versus international stock allocation has about one-fifth (or less) the importance as the bond versus stock allocation.

Rick Ferri
To further what Rick said, perhaps the OP would find it easier to understand if he viewed the overall portfolio as the alternative 2-fund portfolio. That is, Total World Stock and Total Bond. You would still own the three big asset classes, but the major differentiation would be the stock/bond split.

Bob

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Re: Please Help me understand 3-fund portfolio

Post by thethinker » Wed Apr 16, 2014 10:55 am

nisiprius wrote:Blue: stocks. Orange: bonds. Green: cash.

Image


nisiprius, this was a great read, thank you. I do have a few follow up questions if you don't mind.

I know your chart above is only shows a bit more than 20 years of recent history, but is there any case to be made for holding cash? based on this chart, the bond fund never crossed lower than cash.
nisiprius wrote:For most retirement savers, 100% stocks is inappropriate because it has too much risk = volatility = fluctuation.
Can a case be made for 100% investment in a US Stock Index Fund for people in their 20s and 30s who plan to work for at least another 30 years of their life? As long as the fund is not sold at any point over at least a 30 year period and money is invested into the fund each year, could a case be made for this type of strategy?

If I might move off on a tangent (sorry for all of this in a single post), could one just use the lack of an investment as a way to prevent risk? Meaning, 90% stocks and 10% cash is less risky than 100% stocks and maybe less risky than 80/20 in stocks/bonds.
nisiprius wrote:Bonds are much less volatile than stocks and are very effective at diluting stock risk.
history cannot predict the future but if one invested 100% in a vanguard bond fund, how much less of a return should they expect on average as opposed to 100% stocks or a stock/bond mixture?

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Re: Please Help me understand 3-fund portfolio

Post by Angelus359 » Wed Apr 16, 2014 11:26 am

Someone who is in their 20s who wanted to invest 20k for 30 years, yeah sure they can do 100% stocks if they literally never check their accounts.

Personally, I'm emotional, so I can't function that way.

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Re: Please Help me understand 3-fund portfolio

Post by longinvest » Wed Apr 16, 2014 12:26 pm

thethinker wrote:
Can a case be made for 100% investment in a US Stock Index Fund for people in their 20s and 30s who plan to work for at least another 30 years of their life? As long as the fund is not sold at any point over at least a 30 year period and money is invested into the fund each year, could a case be made for this type of strategy?
The problem is that there often is a big difference between a plan and what pans out. Young people are likely to get married (can cost $), buy a house (costs $), have medical emergencies (costs $), get laid off during an economic crisis (costs $), etc.

So, can a case be made? Probably yes if the "not sold at any point over at least a 30 year period" assumption holds. That's a big "if".
Bogleheads investment philosophy | Lifelong Portfolio: 25% each of (domestic/international)stocks/(nominal/inflation-indexed)bonds | VCN/VXC/VLB/ZRR

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Re: Nisiprius answers a question.

Post by Milano » Wed Apr 16, 2014 12:28 pm

thethinker wrote:thank you to everyone who made a post, this has been great information and I am learning lots.
Adding my thanks, having started the three fund portfolio in January, nisiprius's post is crystal clear.

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Re: Please Help me understand 3-fund portfolio

Post by Jnick55 » Wed Apr 16, 2014 12:51 pm

Can a case be made for 100% investment in a US Stock Index Fund for people in their 20s and 30s who plan to work for at least another 30 years of their life? As long as the fund is not sold at any point over at least a 30 year period and money is invested into the fund each year, could a case be made for this type of strategy?
I did exactly that when I began to save for retirement at around age 30 after graduate school. I had a career about which I felt comfortable, my expenses were manageable and I decided that I would not need to touch my retirement money until at least age 60. I had confidence that the stock market would grow more than the bond market over that long of a time horizon. The time horizon was so long that I didn't care about volatility in my portfolio during any of the stock market downturns. I began to diversify into bond funds in my 40s and, now I am approaching my 60s and I am glad that I took that aggressive approach early in my investing career. I would do it again.

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Re: Please Help me understand 3-fund portfolio

Post by Workinghard » Wed Apr 16, 2014 1:32 pm

longinvest wrote:
thethinker wrote:
Can a case be made for 100% investment in a US Stock Index Fund for people in their 20s and 30s who plan to work for at least another 30 years of their life? As long as the fund is not sold at any point over at least a 30 year period and money is invested into the fund each year, could a case be made for this type of strategy?
The problem is that there often is a big difference between a plan and what pans out. Young people are likely to get married (can cost $), buy a house (costs $), have medical emergencies (costs $), get laid off during an economic crisis (costs $), etc.

So, can a case be made? Probably yes if the "not sold at any point over at least a 30 year period" assumption holds. That's a big "if".
Obviously, the expenses above can be somewhat planned. What investment strategy would you recommend for young people? Emergency fund, of course. Stock market index for long term investing, but what about a place to build a a "home" fund? And what percentage balance between long term investing and short term investing (home)?

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Re: Please Help me understand 3-fund portfolio

Post by longinvest » Wed Apr 16, 2014 2:21 pm

Workinghard wrote:
longinvest wrote:
thethinker wrote:
Can a case be made for 100% investment in a US Stock Index Fund for people in their 20s and 30s who plan to work for at least another 30 years of their life? As long as the fund is not sold at any point over at least a 30 year period and money is invested into the fund each year, could a case be made for this type of strategy?
The problem is that there often is a big difference between a plan and what pans out. Young people are likely to get married (can cost $), buy a house (costs $), have medical emergencies (costs $), get laid off during an economic crisis (costs $), etc.

So, can a case be made? Probably yes if the "not sold at any point over at least a 30 year period" assumption holds. That's a big "if".
Obviously, the expenses above can be somewhat planned. What investment strategy would you recommend for young people? Emergency fund, of course. Stock market index for long term investing, but what about a place to build a a "home" fund? And what percentage balance between long term investing and short term investing (home)?
I would say that, for young people starting to invest, the most important is the savings rate not the asset allocation. That is because with a small portfolio, volatility won't have as much impact on the balance as new regularly added money. The initial contribution years will also give them a chance to learn more about their emotional reaction to market volatility. They'll be able to tune their portfolio, over time, to their own ability, need, and willingness to take risk.

Of course, proper planning of various expenses is important (emergency fund, etc.). These should be put into appropriate places (high-interest savings account for emergency fund).
Bogleheads investment philosophy | Lifelong Portfolio: 25% each of (domestic/international)stocks/(nominal/inflation-indexed)bonds | VCN/VXC/VLB/ZRR

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Probability and Possibility

Post by Taylor Larimore » Wed Apr 16, 2014 2:40 pm

History cannot predict the future but if one invested 100% in a vanguard bond fund, how much less of a return should they expect on average as opposed to 100% stocks or a stock/bond mixture?
The thinker:

No one can predict the future.

A wise investor considers Probability AND Possibility.

Best wishes.
Taylor
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Re: Please Help me understand 3-fund portfolio

Post by Orion » Wed Apr 16, 2014 2:57 pm

thethinker wrote:Do people use the 3 fund portfolio because two funds (listed above) are expected to increase if one fund were to fall (for example, if the US Stock Market drops by 30%, do people expect the Bond Fund & International Funds to improve in value?).
This sounds closer to the idea behind the "Permanent Portfolio" which is also occasionally discussed on this forum. The idea of that system is to hold asset classes that are volatile but (generally) inversely correlated so hopefully something is always rising to make up for another component dropping. However, each component in that portfolio could make you very nervous since they include gold, stocks and very long bonds.

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Re: Please Help me understand 3-fund portfolio

Post by cosimdm » Wed Apr 16, 2014 4:28 pm

What does the inflation- adjusted return of the three fund portfolio look like?

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inflation- adjusted return of the three fund portfolio.

Post by Taylor Larimore » Wed Apr 16, 2014 4:39 pm

cosimdm wrote:What does the inflation- adjusted return of the three fund portfolio look like?
Cosimdm:

You will find your answer HERE (in red) in my opening post.

Past performance does not guarantee future performance.

Best wishes.
Taylor
"Simplicity is the master key to financial success." -- Jack Bogle

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Re: Please Help me understand 3-fund portfolio

Post by thethinker » Thu Apr 17, 2014 9:02 pm

longinvest wrote: I would say that, for young people starting to invest, the most important is the savings rate not the asset allocation. That is because with a small portfolio, volatility won't have as much impact on the balance as new regularly added money. The initial contribution years will also give them a chance to learn more about their emotional reaction to market volatility. They'll be able to tune their portfolio, over time, to their own ability, need, and willingness to take risk.

Of course, proper planning of various expenses is important (emergency fund, etc.). These should be put into appropriate places (high-interest savings account for emergency fund).

smart. thank you for adding these points.

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