Three-fund portfolio

A three-fund portfolio is a portfolio which does not slice and dice, but uses only basic asset classes &mdash; usually a domestic-stock "total market" index fund, an international stock "total market" index fund and a bond "total market" index fund. It is often recommended for and by Bogleheads attracted by "the majesty of simplicity" (Bogle's phrase), and for those who want finer control and better tax-efficiency than they would get in an all-in-one fund like a Target Retirement fund.

There is no magic in the number three; the phrase is shorthand for a style of portfolio construction that emphasizes simplicity.

Establishing a three-fund portfolio


A three-fund portfolio is based on the fundamental asset classes, stocks and bonds. It is assumed that cash is not counted within the investment portfolio, so it is not included. On the other hand, it is assumed that every investor should hold both domestic and international stocks. The task, then, is to take these three basic non-cash assets &mdash; domestic stocks, international stocks, and bonds &mdash; decide how much of each to hold (your asset allocation); choose where to hold each of these asset classes, and finally choose a mutual fund to use for each asset class.

Choosing your asset allocation
This is a very important step, and it needs to be done no matter what investment approach you are using. In particular, you must decide for yourself what percentage of stocks to hold, based in part on your personal risk tolerance. There is no shortcut for this step. Even if you are going to use a single Target Retirement fund, you should not take the shortcut implied by the use of a retirement year in the name; you need to decide for yourself what percentage of your your portfolio you want to invest in stocks, and choose the fund that matches it. Even if you are going to use a single LifeStrategy fund, you need to decide which of them to use, based on the percentage of stocks each one holds.

One traditional rough rule-of-thumb is "age in bonds," or percentage of stocks = 100 - age. This is a conservative rule, and leads to smaller percentages of stocks than Vanguard chooses for its Target Retirement series. Another very conservative rule of thumb is one advocated by forum member Adrian Nenu. He suggests that you should work backwards from "maximum tolerable loss." What is the biggest percentage loss you could bear to see in your portfolio without causing you to worry too much and abandon your plan? He suggests your stock allocation should be no more than twice your maximum tolerable loss &mdash; and that most investors should never invest more than 50% in stocks.

The second decision is what percentage of your stock allocation should be U.S. (domestic) and what should be international. This is a much less critical decision because U.S. and international stocks have similar risk profiles and have similar long-term returns. In 2010, Vanguard increased the international allocation of its Target Retirement funds from 20% of the stock allocation to 30%.

See Asset Allocation for more details.

Choosing your asset location
Since your portfolio may be split between multiple locations (one or more tax-advantaged retirement accounts, and one or more taxable accounts) you should look at Principles of Tax-Efficient Fund Placement to determine which funds belong in each account. In general, the international fund should go into a taxable account, the bond fund should go into a tax-advantaged account, and the domestic equity fund should fill in the remaining space.

You may need to hold the same (or equivalent) funds in multiple accounts to have ideal asset allocation and asset location.

Choosing three funds
For Bogleheads, the answer for "what mutual funds" to use in a three-fund portfolio is "low-cost funds that represent entire markets."

If you ask different people to choose funds for a three-fund portfolio, you will get different fund choices. The differences are usually of no fundamental importance, and are usually the result of a) making choices between nearly identical, almost interchangeable funds, and b) simplifying further by using combination package funds. Watch out for high expense ratios, particularly in the bond funds.

Vanguard funds
From Vanguard's list of "core funds," the funds that are best for a three-fund portfolio are:


 * Vanguard Total Stock Market Index Fund (VTSMX)
 * Vanguard Total International Stock Index Fund (VGTSX)
 * Vanguard Total Bond Market Fund (VBMFX)

So, a "three-fund portfolio" might consist of 42% Total Stock Market Index, 18% Total International Stock Index, and 40% Total Bond Market fund.

Bill Schultheis' "Lazy Portfolio" in fact, consists of these three funds in equal proportions.

Fidelity funds
With Fidelity, for example, you could construct a three-fund portfolio using:


 * Fidelity Spartan Total Market Index Fund (FSTMX)
 * Fidelity Spartan International Index Fund (FSIIX) or, perhaps, their soon-to-be-available Fidelity Spartan Global ex-U.S. Index
 * Fidelity Spartan U. S. Bond Index Fund (FBIDX)

Other considerations

 * One could, of course, use ETFs rather than mutual funds. For example, one could use Total Stock Market ETF (VTI), Vanguard FTSE All-World ex-US ETF (VEU) for international, and Vanguard Total Bond Market ETF (BND).


 * A total stock market index fund represents the whole market, while an S&P 500 fund does not. Now that total stock market funds exist and have expenses just as low as S&P 500 funds, total stock market funds are preferable. In practice, the importance and magnitude of the difference is a subject of debate. In a 401(k) plan with limited choices one might very well opt for an S&P 500 index fund to serve as the domestic stock component of a three-fund portfolio. Alternatively, you can approximate a Total Stock Market fund by combining an S&P 500 index fund with one or more mid-cap and small-cap funds.  There are "completion index" funds such as Vanguard's Extended Market fund (available as an open-end fund as VEXMX and as an ETF as VXF) which can be added to an S&P 500 fund in a specified ratio to produce a hybrid which should perform like a Total Stock Market fund.


 * Vanguard perplexes investors by offering two virtually interchangeable international stock market index funds: Vanguard Total International Stock Index Fund (VGTSX) and Vanguard FTSE All-World ex-US (VFWIX). See Should I buy Total International or FTSE All-World ex-US for the details.


 * Be aware of any minimum investment required by each fund; for instance, the Investor shares of most Vanguard funds require a minimum investment of $3000.00; lower-cost Admiral shares typically require a minimum of $10,000.00. If you will have difficulty meeting these minimums, you may want to consider an all-in-one single-fund portfolio until you accumulate enough that this is not an issue.

Combining domestic and international stocks
The relative percentage of domestic and international stocks is a subject of intense discussion in the forum. One sensible option is to hold domestic and international stocks in the same proportions as they represent in the total world economy. That would currently mean about 40% U. S. and 60% international. This option is recommended by Burton Malkiel and Charles Ellis, both of whom have longstanding ties to Vanguard, in their book The Elements of Investing. Other authorities suggest holding less than that, and Vanguard currently allocates 30% of stock to international in its Target Retirement funds, and in their research, advise holding 20% - 40% international allocations. If your own preference is for a "total world" weighting, then the portfolio can obviously be simplified using Vanguard's Total World Stock Index fund, which is exactly what Malkiel and Ellis suggest. Such a two-fund portfolio would use these funds:


 * Vanguard Total World Stock Index Fund (VTWSX) for both domestic and international stocks
 * Vanguard Total Bond Market Index Fund (VBMFX)

Combining stocks and bonds
The Vanguard Balanced Index Fund holds 60% Total Stock Market Index Fund and 40% Total Bond Market Index Fund. By adding an international stock fund, one could create a two-fund portfolio.

The LifeStrategy and Target Retirement funds are three-fund portfolios!
Starting in late 2011, the LifeStrategy funds will employ the three broad total domestic, international and bond market indexes making up the three-fund portfolio. These funds are target risk portfolios as they employ a static target for asset allocations.

It's interesting to notice that Vanguard's Target Retirement funds are, essentially, simple three-fund portfolios. In the past this was slightly obfuscated by the use of three separate international funds instead of a single fund, but since September 27, 2010, Vanguard has completely transitioned from the component funds (Vanguard European Stock Index Fund, Vanguard Pacific Stock Index Fund, and Vanguard Emerging Markets Stock Index Fund) to the-broad based, Vanguard Total International Stock Index Fund. This means that most of the Target Retirement funds now literally consist of three funds: Total Stock Market Index, Total Bond Market II Index, and Total International Index.

Some see advantages in holding a do-it-yourself three-fund portfolio rather than a LifeStrategy fund or Target Retirement fund, even if the same three funds are used. The advantages are small but meaningful to some, and include:


 * Improved tax efficiency for taxable investors by placing each fund in its best location


 * Direct control over allocation percentages


 * Independence from Vanguard's small course changes in the Target Retirement funds (as when they increased stock allocation in 2006, and changed domestic-to-international ratio in 2010)


 * Availability of slightly-lower-cost Admiral shares in the individual funds, but not the Target Retirement funds

Adequacy of a three-fund portfolio
One Marketwatch article quotes various non-Boglehead commentators as saying such things as "You can make it really simple, be well-diversified, and do better than two-thirds of investors" and "That three-pronged approach is going to beat the vast majority of the individual stock and bond portfolios that most people have at brokerage firms... there is a certain elegance in the simplicity of it."

As noted above, Vanguard itself uses what is essentially a three-fund approach in its Target Retirement funds, an endorsement of its adequacy.

In her Forbes article, How To Diversify With Just Three Funds, Boglehead Laura F. Dogu describes this approach and comments "With only these three funds, investors can create a low cost, broadly diversified portfolio that is very easy to manage and rebalance.... Some investors may be uncomfortable with holding only three funds and will question whether they are truly diversified. With these three holdings the answer on diversification is a resounding 'YES'."

Some would argue that a three-fund portfolio is good enough and that there is no real proof that more complicated portfolios are any better. Others would argue that the evidence for superiority of slice and dice, "small value tilting," and inclusion of classes like REITs is too strong to ignore.

Contrasted with other approaches
There are single, all-in-one, "funds of funds" that are intended to be used as an investor's whole portfolio. Vanguard funds in this category include the Target Retirement funds, the LifeStrategy funds; perhaps the actively-managed Wellington and Wellesley funds would qualify, too.

On the one hand, a three-fund portfolio involves a do-it-yourself aspect that makes it more complicated than using an all-in-one fund. For example, because different assets grow at different rates, any investor who chooses a do-it-yourself approach needs to "rebalance" occasionally &mdash; perhaps annually &mdash; in order to maintain the desired percentage mix.

On the other hand, three-fund portfolios are simpler than the genres called "Coffeehouse portfolios" (William Schultheis's term), "couch potato" portfolios, or "lazy portfolios," which are intended to be easy for do-it-yourselfers but are nevertheless slice-and-dice portfolios using six or more funds.

Lazy portfolios
"Lazy portfolios" are specific portfolio suggestions, often involving three funds, with suggested percentages, such as "1/3 Total Stock Market Index, 1/3 Total International Stock Market Index, 1/3 Total Bond Market Index." The term has been popularized by Paul B. Farrell, who writes MarketWatch columns about various simple portfolios. Instead of going through the step of deciding on your own asset allocation, you accept the suggestion that, say, 2/3 stocks to 1/3 bonds and half-and-half domestic and international is a good enough, one-size-fits-all allocation.

Other variations
A three-fund combination can serve as the core of a more complex portfolio, where you add a small play money allocation or a tilt to some corner of the market that interests you.