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, and is related to lazy portfolios.

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%.

Vanguard's tool
As of 2012, Vanguard provides a tool that recommends a balanced portfolio similar to the kind discussed here (Vanguard recommends a four fund portfolio), with percentages based on your responses to a short online questionnaire. The tool is entitled Get a recommendation to fit your goals; you can navigate to it by way of Vanguard.com, Go to personal investors' site, What we offer: Mutual Funds, Get a Recommendation.

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.

One could, of course, use ETFs rather than mutual funds. For example, one could use Total Stock Market ETF (VTI), Vanguard Total International Stock Index Fund (VXUS) for international, and Vanguard Total Bond Market ETF (BND).

Other than Vanguard, Boglehead-style
The building blocks of Boglehead-style investing are low-expense-ratio index mutual funds and/or ETFs. Vanguard fans would suggest that Vanguard has the best and most complete lineup of such funds, and that the most convenient place to hold Vanguard mutual funds is directly at Vanguard. Thus, the Bogleheads forum and Wiki tends to be Vanguard-oriented. But investing according to the Boglehead philosophy certainly does not require you to invest at Vanguard or use Vanguard products. Here are some suggestions on how to do it with other funds. (Refer to the associated wiki article for additional information.)


 * With mutual funds:


 * With Exchange-traded funds:

Other considerations

 * 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.

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."

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.

It's 2013. What about bonds?
As of 2013 when this is being written, bond interest rates are at historic lows and there is a good deal of buzz to the effect that the "thirty-year bull market in bonds has ended" and that investing strategies that have worked for decades should be changed to reflect new realities. Should the three-fund portfolio be modified? No definitive answer can be given to this controversial question, but we can sketch out some of the prevalent and conflicting opinions on the matter.
 * 1) Some would say that advocates of complex investing strategies always have reasons why simple approaches "once worked but don't work any more." Advocates of simplicity might say to ignore the noise and continue to stay the course; it may turn out that something else does better--something always does--but that a three-fund portfolio is still good enough.
 * 2) In 2013, Vanguard altered the composition of its Target Retirement funds; from 2010 to 2013, most of them were literally three-fund portfolios as described here. Now, the bond portion has been modified to include international bonds; specifically, the bond allocation is now 80% Vanguard Total Bond Market Index Fund and 20% Total International Bond Index Fund. Nothing Vanguard has published would lead one to believe that this is a big change or that it will have a big effect. Some may find it appealing to follow Vanguard's lead.
 * 3) Some well-informed Bogleheads make a strong case that the "bond" component of a three-fund portfolio might well be filled with non-brokered bank CDs instead of a traditional bond fund.
 * 4) Suggestions 2 and 3 are adjustments that don't radically change the risk of the bond component. For the record, it should be stated that Burton Malkiel and Charles Ellis, in the 2013 edition of their book Elements of Investing, made a controversial and much more radical suggestion, which shocked many forum members. But, because they were early champions of indexing, each with long associations with Vanguard, their suggestion should be noted. They seemed to be recommending the replacement of a traditional high-grade bond fund with a 50/50 mix of emerging markets bonds and a high-dividend stock fund. Using Vanguard's "risk potential" categories, that means they are recommending replacing a holding in risk potential category 2 with a mix of holdings in categories 3 and 4.

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.

The LifeStrategy and Target Retirement funds are four-fund portfolios
The Vanguard Target Retirement funds and LifeStrategy funds employ a four fund allocation matrix. The funds include:


 * Vanguard Total Stock Market Index Fund
 * Vanguard Total International Stock Index Fund
 * Vanguard Total Bond Market II Index Fund
 * Vanguard Total International Bond Index Fund

Some see advantages in holding a do-it-yourself four-fund portfolio rather than a LifeStrategy fund or Target Retirement fund, even if the same four 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, and added international bonds in 2013)


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

Historic notes

 * Scott Burns wrote a 1991 article, Exactly How To Be A Couch Potato Portfolio Manager. The original "basic, humble, couch potato portfolio" consisted of two funds, "the Vanguard Index 500 fund, which mimics the Standard and Poors' 500 index, and the Vanguard Fixed Income Short Term Government Bond Fund."
 * Taylor Larimore was an early advocate of this approach, which he described in 1999 in a Morningstar posting, Which is better, 15 funds or 4? He stated that "It is no longer necessary to own large portfolios. Now, with only four funds, it is possible to own all the securities in every asset-class, style, and cap-size, in exact proportion to their market weight. These four funds are: Total Stock Market Fund, Total Bond Market Fund, Total International Fund and a Money-Market Fund."