One of the biggest decisions you'll make as an investor is your investing strategy. There's a near-endless number of approaches out there. It's important to find one that you're comfortable using so you're happy with the results and not second-guessing if you should stick with it.
The three-fund portfolio is a strategy that gets lots of love from investors, and for good reason. It can deliver strong growth and low risk over long time periods, and it's easy to manage. If you're trying to figure out how to set up your investments, the three-fund portfolio could be the solution.
What is the three-fund portfolio?
The three-fund portfolio is an investment portfolio with U.S. stocks, international stocks, and U.S. bonds. As the name suggests, it contains three investment funds:
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- Total stock market index fund
- Total international stock index fund
- Total bond market fund
Exact asset allocation depends on each investor's age and risk tolerance. Younger investors may put more of their portfolios in the stock market funds. Older investors who are closer to retirement will likely want more money in bonds.
The Bogleheads, a term for investors who follow the investing philosophy of Vanguard founder John Bogle, popularized the three-fund portfolio. It's now the portfolio of choice for many investors.
How to build a three-fund portfolio
To build a three-fund portfolio, invest in a total stock market index fund, a total international stock index fund, and a total bond market fund. These can be either mutual funds or ETFs (exchange-traded funds). What's most important is that they have low fees -- an expense ratio of under 0.10% is ideal, without any transaction fees for buying and selling.
You can find these three types of funds with all the popular stock brokers. Some have their own version of these funds, but there's little difference between them. You don't need to worry about whether a total stock market fund from Vanguard or Charles Schwab is better. Choose whichever is most convenient for you and available with the broker you use.
The other consideration is your asset allocation between these funds. Here are a few popular options:
- An 80/20 three-fund portfolio with 64% U.S. stocks, 16% international stocks, and 20% bonds. This option prioritizes growth and is good for investors with high risk tolerance.
- An equally weighted three-fund portfolio with 33% to 34% in each asset. This option is balanced, with moderate growth potential and risk.
- A 20/80 three-fund portfolio with 14% U.S. stocks, 6% international stocks, and 80% bonds. This option is highly conservative and designed for preserving wealth.
Pros and cons of the three-fund portfolio
There are quite a few benefits to the three-fund portfolio. Here are some of the biggest advantages of this strategy:
- You have a diversified portfolio containing over 10,000 securities.
- It keeps fees to a minimum, since you're investing in index funds with low expense ratios.
- It performs well for long-term investors. U.S. and international stocks have strong growth potential, and bonds provide stability.
- You can set up the asset allocation to fit your needs, so you have some control over how your portfolio is set up.
- It doesn't take long to build or to maintain. All you need to do is keep your asset allocation where you want it.
No investing strategy is perfect for everyone. Here are the most notable drawbacks to the three-fund portfolio:
- Although it's not too time-consuming, you can't "set it and forget it." If you're looking for a completely hands-off portfolio, a target-date fund may be a better choice.
- You don't have full control over your portfolio if you follow this strategy as intended. You only invest in those three types of funds, meaning no stock picking or alternative investments, such as real estate or crypto.
- Bonds can limit your portfolio's growth. While you can keep bond allocation to a minimum with the three-fund portfolio, some may prefer to hold off on bonds entirely when they're decades from retirement.
Is a three-fund portfolio right for you?
The three-fund portfolio is a sound investing approach, and you can't go wrong with it. If you set up asset allocation appropriate for your age, a three-fund portfolio will most likely perform well. I say "most likely" because nothing is guaranteed with investing, but this strategy is one of the safer options.
There are situations where another approach could be a better choice. If you aren't interested in bonds for the time being, then the three-fund portfolio isn't for you. If you want full control over your portfolio, stock picking may be the way to go. But if you're looking for a straightforward strategy with good performance and no glaring flaws, the three-fund portfolio fits the bill.
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