The 3 fund portfolio is one of the most popular investment strategies. It requires minimal effort, diversifies your portfolio and keeps your investing costs low.
With three index funds, you get exposure to stocks and bonds for most United States investment sectors plus the largest international assets.
As you near retirement, you can keep these funds and make small adjustments to rebalance your portfolio periodically. Here is a closer look at how to invest with only three funds and earn passive income.
In This Article
- What Is the Three-Fund Portfolio?
- Who Is the Three-Fund Portfolio For?
- Three-Fund Portfolio Asset Allocation
- Three-Fund Portfolio Benefits
- How to Succeed With the Three-Fund Portfolio
- Three-Fund Portfolio Alternatives
What Is the Three-Fund Portfolio?
The three-fund portfolio is a passive investing strategy originating in the Boglehead community. This group mainly includes index fund investors who use Vanguard, the brokerage that made passive index funds famous.
Instead of trying to guess which companies will outperform the overall stock market each year, you simply invest in three index funds.
These funds hold a position in the most publicly-traded companies, whether they’re in a large-cap, mid-cap or small-cap index.
The standard three-fund portfolio holds these index funds:
- U.S. total stock market index fund
- U.S. total bond market index fund
- International total stock market index fund
While you can hold these funds through Vanguard, most online brokerages offer similar funds with comparably low expense ratios.
Passive investing through indexes may not feel as exciting as investing in individual stocks or day trading as you hope to find the next Amazon, Apple or Tesla. However, studies show that active investors usually underperform the market.
This investing strategy favors index funds. These funds have less investment risk since they are highly diversified. Additionally, your investment fees are low.
Better yet, index fund investing is less time-consuming than researching individual stocks or actively-managed funds. Most people don’t have the time, desire or skill to analyze stocks like a professional investor.
Who Is the Three-Fund Portfolio For?
You should consider this portfolio if you want to invest in index funds that give you instant exposure to most stocks and bonds. It’s also a good option if you are comfortable managing your portfolio.
With this strategy, it’s reasonable to expect returns similar to the annual performance of the overall stock and bond market.
This portfolio is also easy to self-manage, so you don’t have to pay a financial advisor a fee to create a similar asset allocation.
It’s possible to invest in total stock and bond index funds with any free investing app. Furthermore, this portfolio can be a good fit for your taxable, IRA and 401k accounts.
Three-Fund Portfolio Asset Allocation
While you can invest in the same index funds as other investors, your asset allocation depends on your age and investing goals.
These are the three fund categories you might buy, including ticker options:
|U.S. Stocks||Total Stock Market ETF (Ticker: VTI)||Fidelity ZERO Total Market Index Fund (Ticker: FZROX)||Schwab U.S. Broad Market ETF (Ticker: SCHB)||iShares Core S&P Total U.S. Stock Market ETF (Ticker: ITOT)|
|U.S. Bonds||Total International Bond ETF (Ticker: BNDX)||Fidelity Total Bond ETF (Ticker: FBND)||Schwab U.S. Aggregate Bond ETF (Ticker: SCHZ)||iShares Core Aggregate Bond ETF (Ticker: AGG)|
|International Stocks||Total International Stock ETF (Ticker: VXUS)||Fidelity ZERO International Index Fund (Ticker: FZILX)||Schwab International Equity ETF (Ticker: SCHF)||iShares Core MSCI Total International Stock ETF (Ticker: IXUS)|
You may prefer index ETFs because they tend to have lower expense ratios and investment minimums than index mutual funds.
Here are some factors to consider as you build your portfolio.
Bonds vs. Stocks
With the three-fund portfolio, you get exposure to stocks and investment-grade bonds. However, it’s important to understand the potential risks and rewards for either asset.
Your stock index funds let you enjoy the long-term growth benefits of appreciating stock prices and some dividend income.
Keep in mind that stocks are inherently riskier than bonds. As a result, you will gradually reduce your exposure as you approach retirement. This helps you avoid a steep potential drop in your portfolio value when you rely on fixed income.
Bonds don’t have explosive growth potential like stocks, yet they can have higher dividend yields and less downside risk. As you grow older, your portfolio will favor bonds and switch to a capital preservation strategy.
How much you should invest in stocks vs. bonds mostly depends on your age as well as your planned retirement date.
Younger investors should primarily hold stock funds since they have a higher risk tolerance for the volatility that accompanies the long-term growth potential of these equities.
You will reduce your stock exposure and increase your bond allocation as you grow older.
Here are some of the potential asset allocations to consider.
Equal Weight Allocations
You may decide to assign an equal one-third allocation to each holding. This means that each fund has a 34% allocation for U.S. stocks and 33% for the remaining two funds.
An equal weight fund gives you more exposure to international stocks than an age-based strategy or one that prioritizes United States-based companies.
Many model portfolios base your stock and bond allocation on your current age.
A common rule of thumb is subtracting your age from 110 or 120, and the difference is your stock percentage allocation. For example, a 20-year-old subtracting their age from 110 will have a 90% stock allocation.
Interestingly, the baseline for this strategy used to be 100. Many people now use a bigger number because of higher life expectancies and low bond yields that can hurt older investors.
Here’s a more detailed breakdown of allocation based on age:
|Age||Stock Allocation||Bond Allocation|
This table uses the “Rule of 110” to determine the stock and bond allocation.
When it comes to how much to invest in U.S. and international stocks, you can use your risk tolerance to decide.
International stocks are historically riskier than U.S. stocks but may have more upside potential if the global economy grows more quickly than the economy in the United States.
Use these risk tolerance guidelines to determine your international stock exposure:
- Conservative: 20-25% (of your stock allocation)
- Moderate: 30-35%
- Aggressive: 40% to 50%
Using a 20% international stock allocation, here are the 3-fund portfolio percentages:
|Stock/Bond Mix||U.S. Stocks||Foreign Stocks||U.S. Bonds|
A portfolio analysis tool can help recommend an asset allocation for your investing goals.
Three-Fund Portfolio Benefits
There are many benefits to a three-fund portfolio. Here are some of the top perks of choosing this investment method.
Diversification is key in any investment strategy, and the three-fund portfolio allows you to diversify your holdings.
Holding these three funds gives you instant access to these asset classes:
- U.S. stocks (large, mid and small-cap)
- International stocks (developed markets)
- U.S. investment-grade bonds (government and corporate)
These investment sectors tend to have the most reliable returns and less volatility than focusing on a specific sector or company size.
If you choose index funds that focus on a specific sector or a market cap, such as an S&P 500 ETF, you may miss out on some of the potential investment gains of the total market.
Achieving total market exposure can also allow for more balance returns and reduced volatility.
Easy Asset Allocation
This portfolio strategy is one of the easiest ways to get exposure to stocks and bonds within your risk tolerance.
By investing in broad-based total market funds, you can invest in more sectors with fewer funds. This strategy also makes it harder to overlook the best-performing assets for the current year.
Additionally, a simple portfolio is easier to maintain during your routine rebalance.
Index funds can reduce your investment costs in several ways. In turn, these savings give you more money to invest.
Lower Expense Ratios
Passive funds have lower management fees than active funds that try to outperform their benchmark index. This is because they sell holdings less frequently.
A smaller expense ratio means you have more cash to invest in the market.
Fewer Trading Commissions
While most investing apps offer commission-free trades, some brokerages may charge a fee to buy or sell investments.
When you have just three funds, you’ll make fewer trades and reduce any fees you may need to pay.
Minimal Taxable Events
If you sell a stock or fund in a taxable brokerage account, you have to report the sale on your income tax return.
Only having three funds reduces the likelihood of selling an underperforming position to maintain a balanced portfolio.
Broad-market index funds are inherently less risky than individual stocks and sector ETFs because they invest in a higher number of companies and industries. Your portfolio performance can match the overall market that you invest in.
While you may not have as much upside potential if you invest in this year’s best-performing stocks, your downside risk is lower if an investment idea underperforms the broad market.
This investment strategy doesn’t involve special skills or tons of research because you don’t have to screen potential stocks and funds.
However, it’s still a great idea to understand how your investments work and the potential market risks. Knowing these factors can help you choose an appropriate asset allocation and avoid panic selling during a bear market.
How to Succeed With the Three-Fund Portfolio
Your probability of being a successful investor using this investment strategy can increase by implementing these suggestions.
Establish Goals and Objectives
Knowing your planned withdrawal date, desired final portfolio value and the estimated annual rate of return can help you choose the best stock and bond asset allocation.
You can switch to a more aggressive or conservative risk tolerance as your goals change.
No investment will generate positive returns every single year. Unfortunately, nobody can accurately predict the stock market performance consistently.
As a result, you might choose a dollar-cost averaging (DCA) strategy where you invest a fixed amount of money each month.
With this strategy, no matter what’s happening in the market, you invest the same amount and hold more shares that can earn dividend income.
If you try timing the market by buying low and selling high, you may go several years without investing while you wait for a better entry price. Sadly, that opportunity may never come, and you might need to invest a larger amount to catch up.
Think About the 4% Rule
Your withdrawal strategy can be as vital as choosing your asset allocation and monthly contribution. Many financial planners use the 4% rule as a guideline to estimate your annual retirement withdrawals.
For instance, if you plan to withdraw $40,000 per year, your portfolio must be at least $1 million.
In short, consider investing enough so you can afford to withdraw up to 4% of your portfolio value each year in retirement.
Remember that it’s better to invest too much instead of too little as retirement expenses and your life expectancy can be difficult to predict accurately.
Here are some questions you may have about investing with a three-fund portfolio to determine if it’s the right option for you.
Yes. This is an effective investment strategy for many investors because you have ample diversification to most publicly-traded stocks and bonds.
Maintaining a proper asset allocation for your risk tolerance can optimize your investment returns.
Maybe. You should consider this strategy if you want to invest in index funds with low fees and get instant diversification.
This portfolio is also easy to rebalance and requires little maintenance like trading individual stocks.
This investment idea is one of the least volatile ways to invest in stocks and bonds since your investment performance can be similar to the overall market.
Only investing in specific individual stocks and sector ETFs instead of passive index funds is riskier since you have exposure to fewer companies.
Broad market index funds that invest in domestic stocks, bonds and international stocks are the best fit for this strategy because you can achieve total market diversification.
Three-Fund Portfolio Alternatives
You may consider these alternative portfolios to customize your investment strategy. It’s possible to choose a simpler strategy or add additional funds to get exposure to more assets.
Picking a target-date retirement fund nearest to your planned retirement date lets you invest in stocks and bonds with a single fund.
Instead of managing your asset allocation, the fund manager decides how much to invest in stocks and bonds.
There are several different retirement fund providers to invest in. Research the investment strategy and asset allocation to choose the best fund for your goals.
If you only want to invest in domestic assets, you may decide only to buy the U.S. total market stock and bond funds.
As most U.S. companies have overseas operations, you can still get indirect exposure to international stocks with potentially less risk.
One downside of the three-fund portfolio is not having exposure to international bonds. A four-fund portfolio gives you the flexibility of investing in an investment-grade international bond index fund.
Alternately, you may decide to invest in a specific stock index like the S&P 500 or Nasdaq 100. This can give you additional exposure to the largest traded companies on the U.S. stock market.
A five-fund portfolio lets you invest in a specific asset class. Your additional funds may invest in stocks or bonds not part of the total market ETFs.
Some examples include:
- Real estate investment trusts (REITs)
- Treasury Inflation-Protected Securities (TIPs)
- Small-cap stocks
- Emerging markets
The key is investing in passive index funds that keep your expenses low.
Since these funds can be more volatile because they are less diversified, you may assign a smaller portfolio allocation to minimize your portfolio risk.
The three-fund portfolio makes investing more straightforward and doesn’t require any special skills. This method is excellent for new and experienced investors alike.
As stock market investing is one of the most popular passive income ideas, a three-fund portfolio lets you quickly build a core portfolio built for long-term growth while earning recurring dividends.