The Lazy Portfolio That Beats Most Pros: The Three-Fund Portfolio

Investing can often seem daunting, but there's a straightforward approach that makes it remarkably simple: the three-fund portfolio. In this guide, I'll demystify what a three-fund portfolio is, why it's gained such popularity, and how you can construct one yourself. By the end, you'll realize that just three low-cost index funds can provide you with broad diversification with minimal effort. This strategy, championed by followers of Vanguard founder John Bogle, is celebrated for its simplicity and cost-effectiveness. Let's delve into this uncomplicated yet powerful investment strategy!

What is a Three-Fund Portfolio (and Why Is It Popular)?

A three-fund portfolio is an investment portfolio built using just three broad asset classes. In practice, this means holding three funds: a U.S. stock index fund, an international stock index fund, and a bond index fund. Each fund is a low-cost index fund that tracks a significant portion of the market. Combined, they cover almost the entire investable market, including U.S. and global stocks, as well as bonds.

But why is this so popular? For one, it's simple. With just three funds, you eliminate the complexity of juggling many investments. Yet, it is diversified; you are effectively owning thousands of stocks worldwide and a broad mix of bonds in one easy combination. This diversification helps reduce risk, since your money isn't tied to any single company or sector. What's more, it's incredibly cost-effective: index funds charge very low fees (often 0.1% or less), ensuring that more of your money stays invested. This makes it a favorite 'set it and forget it' strategy for both beginners and seasoned investors, and it's a testament to your financial prudence.

Typical Asset Allocation: U.S. Stocks, International Stocks, and Bonds

One of the key advantages of the three-fund portfolio is its adaptability. You can adjust the allocation of each of the three funds to align with your objectives and risk tolerance. For instance, younger investors might opt for a more aggressive approach, with a higher percentage in stocks (split between U.S. and international) and a smaller portion in bonds. On the other hand, those nearing retirement might prefer a larger bond allocation for stability.

The main point is to include all three categories, so you have a bit of everything.

Choosing Low-Cost Index Funds for Each Asset Class

One of the best parts of the three-fund approach is that any major brokerage can provide the ingredients. Whether you invest with Vanguard, Fidelity, Schwab, or another firm, you'll find index funds or ETFs covering each category. Here are some popular low-cost index fund examples for each component of a three-fund portfolio:

• U.S. Stock Fund: Vanguard Total Stock Market Index (VTSAX, or ETF version VTI) gives you exposure to virtually the entire U.S. stock market. Fidelity's equivalents would be the Fidelity Total Market Index Fund (FSKAX) or even their zero-fee option FZROX. Charles Schwab offers the Schwab Total Stock Market Index Fund (SWTSX) as well. All of these funds let you own thousands of U.S. companies in one go for a very low expense ratio.
• International Stock Fund: To cover the rest of the world, you'd use a total international stock index fund. Vanguard's option is the Total International Stock Index (VTIAX, or ETF VXUS). Fidelity offers the Total International Fund (FTIHX) or zero-fee FZILX. Schwab's choice is the Schwab International Index Fund (SWISX), which covers a broad range of overseas stocks.
• Bond Fund: For the bond option, a total bond market index is commonly used. Vanguard's Total Bond Market Index Fund (VBTLX, or ETF BND) is a broad index of investment-grade U.S. bonds. Fidelity's U.S. Bond Index Fund (FXNAX) serves the same role, as does the Schwab U.S. Aggregate Bond Index Fund (SWAGX). These funds provide exposure to a mix of government and corporate bonds, helping stabilize your portfolio when stocks are volatile.

Pros of the Three-Fund Portfolio

• Simplicity and Ease of Use: With only three pieces to manage, this strategy is simple. You avoid the confusion of complex strategies and can invest with confidence even as a beginner. Essentially, you own "the entire market" with a few funds, so you never have to worry about picking the right stock or sector.
• Low Cost: Three-fund portfolios typically use index funds, which are among the cheapest investment options. Many total market index funds charge expense ratios under 0.1% per year. When you keep costs that low, virtually all of your investment returns stay in your pocket.
• Tax Efficiency: If you invest via a taxable account, a three-fund portfolio can be structured in a tax-efficient way. Index funds generally have low turnover, which means they minimize capital gains distributions (so you owe less tax each year). You can also practice tax-efficient fund placement. For instance, you can hold your bond fund in a tax-deferred IRA to avoid yearly taxes on bond interest, while keeping stock index funds in a taxable account.

Cons of the Three-Fund Portfolio

• Market-Matching Returns: Since a three-fund portfolio uses broad index funds, it's designed to match the market, not beat it. You won't outperform the market averages with this approach; by definition, you're accepting the market's returns.
• Requires Some Maintenance: "Set it and forget it" is almost true here, but not entirely. You should check in periodically and rebalance to keep allocations on target, maybe once or twice a year. But it's not completely hands-off. By contrast, a target date mutual fund would rebalance automatically for you. With three funds, you are the manager, so you have to remember to do a little upkeep. The good news is that it's easy to monitor, and many brokerages will even let you set alerts or automatic rebalancing in some cases.
• Behavioral Discipline Needed: This isn't much a flaw of the portfolio as a reminder: as with any investing strategy, you'll need the discipline to stay the course. A three-fund portfolio will still go through market drops, sometimes severe ones, because it's mostly stocks. You must be willing to trust the process and not panic-sell when one part of the portfolio is down.

The Bottom Line

The three-fund portfolio offers a clear, warm welcome to the world of investing. By combining just three low-cost index funds, you get exposure to thousands of stocks and bonds across the globe, a level of diversification that would satisfy even the most cautious financial advisor. This strategy has a long track record and is beloved by proponents of passive investing for a reason: it works, and it doesn't drive you crazy in the process.

In the end, whether you stick with a three-fund portfolio for life or use it as a stepping stone, it teaches an invaluable lesson: investing doesn't have to be complicated to be effective. Sometimes, the simplest solution truly is the best. So if you're looking for a straightforward, time-tested strategy, the three-fund portfolio might be the perfect fit to grow your money while you focus on living your life!

Disclaimer: This article is for educational purposes only and does not constitute financial, investment, or legal advice. Investing involves risk, including the potential loss of principal. Past performance is not indicative of future results. Always do your own research or consult with a licensed financial advisor before making investment decisions.