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 beginners who want a little more "hands-on" control than they would get in an all-in-one fund like a Target Retirement fund.

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; choose a mutual fund to use for each asset class and decide how much of each to hold (your asset allocation).

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 (overseas?) This is a much less critical decision because U. S. and foreign stocks have similar risk profiles and are not really all that different. In its Target Retirement funds, Vanguard has recently increased the international allocation from 20% of total stocks to 28%.

See Asset Allocation for more details.

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." From Vanguard's list of "core funds," the funds that do that 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.

If you ask someone to choose funds for a three-fund portfolio, you might 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.

Interchangeable funds
a) Obviously, of course, one might use a different fund company's funds. With Fidelity, for example, one could construct a three-fund portfolio using Fidelity Spartan Total Market Index Fund, Fidelity Spartan International Index Fund, and Fidelity U. S. Bond Index Fund. The same could be done at other fund companies. (Watch out for expense ratios, particularly in the bond funds).

b) 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.

c) 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.

d) 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).

Combining funds
401(k) plans generally offer a limited menu of fund options and as a result may not have a suitable fund of each type. Most commonly, you may need to 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.

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 uses 28% 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 Target Retirement funds are three-fund portfolios!
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 going forward Vanguard has announced that they will "replace the three component funds (Vanguard European Stock Index Fund, Vanguard Pacific Stock Index Fund, and Vanguard Emerging Markets Stock Index Fund) that currently provide international stock exposure in the Target Retirement Funds with a single fund, Vanguard Total International Stock Index Fund." This means that most of the Target Retirement funds will literally consist of three funds: Total Stock Market Index, Total Bond Market II Index, and Total International Index.

One reason for holding a do-it-yourself three-fund portfolio rather than a Target Retirement fund would be that you wish to tune the mix differently from Vanguard, while Vanguard only provides one glide slope and one asset allocation for each 5-year cohort of investors.

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.

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.