3-fund portfolio: What it is and how it works

Much of the investing and financial advice landscape is complex, and often unnecessarily so. For most people who are saving for retirement, a portfolio that holds a combination of stocks and bonds will be the best path for achieving their goals. This simple approach can get complicated quickly, however, with advisors recommending different funds and changing asset allocations based on market predictions.

The idea of a three-fund portfolio appeals to many investors because it simplifies the investment process by focusing on the key asset classes you need exposure to and minimizing the fees you pay along the way. Here’s more on the three-fund portfolio and how you can build one for yourself.

What is a 3-fund portfolio?

A three-fund portfolio is an investment strategy that involves holding mutual funds or ETFs that invest in U.S. stocks, international stocks and bonds. The strategy is popular with followers of the late Vanguard founder John Bogle, who valued simplicity in investing and keeping investment costs low.

The strategy focuses on gaining broad exposure to key asset classes by holding low-cost index funds. Investors following this strategy will look for total-market index funds that track an entire market such as U.S. or international stocks. The resulting portfolio typically offers good long-term growth prospects, diversification benefits and some current income from the bond allocation.

The three funds can be held in different amounts based on the investor’s risk tolerance and how close they are to meeting their goals. If the funds are held in equal one-third weights, it would translate to a portfolio that is made up of two-thirds stocks and one-third bonds.

How to build a 3-fund portfolio

A three-fund portfolio consists of a U.S. total market stock fund, an international total market stock fund and a total market bond fund. These funds can be purchased through online brokers, and you typically shouldn’t have to pay an expense ratio of more than 0.10 percent.

Once you’ve identified the funds you’d like to purchase, you’ll need to determine how much to invest in each fund. In general, investors who still have decades before they plan to retire will hold a greater portion of stocks compared to bonds, while those who are close to retirement or already retired will have more invested in bonds.

One simple formula to determine the percentage of your portfolio to hold in stocks is to subtract your age from 100 (100 – age = amount in stocks). However, some experts think this approach is overly conservative.

Pros and cons of a 3-fund portfolio

Pros

• Simplicity: One of the main attractions of the three-fund portfolio is its simplicity. You’re essentially owning the entire stock market and bond market, so you don’t have to worry about whether now is the time to buy small-cap growth stocks or if you should take a chance on high-yield bonds. It’s just three funds and that’s all you have to keep track of.

• Diversification: By holding total-market index funds that track stocks and bonds, you’re choosing to hold a diversified portfolio. This means that your fortunes aren’t tied to any one security and you will receive the total market return from stocks and bonds.

• Low costs: Total-market index funds can be purchased for low costs, typically less than 0.10 percent annually and often even cheaper. Keeping expenses low is one of the best ways for investors to make sure that more of the investment return ends up in their pocket.

Cons

• Requires monitoring: One downside of the three-fund portfolio is that it will require monitoring and rebalancing from time to time. You won’t just be able to set it and forget it. You’ll probably want to rebalance the portfolio to make sure it’s inline with your desired allocation at least on a quarterly basis.

• Could miss out on higher returns: By deciding to hold a diversified portfolio of index funds, you’re also agreeing to miss out on the higher returns that can come from owning individual stocks or funds that may outperform over certain periods.

• Won’t own alternative investments: The three-fund portfolio doesn’t allow for alternative investments such as real estate or commodities, so if this is something you’re interested in you may want to have a separate allocation for alternatives.

Bottom line

The three-fund portfolio is a simple investment strategy that should meet the needs of most investors. It offers a diversified portfolio at a low cost and allows you to customize the asset allocation based on your investment goals and risk tolerance.

Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.