Investing With a Three Fund Portfolio

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I’ve talked in the past about several ways of effectively outsourcing the management of your investment portfolio.

Possibilities range from using an all-in-one mutual fund to engaging a service like Betterment to hiring a financial advisor.

That being said, you may be interested in maintaining a bit more control and/or avoiding the extra fees associated with an investing service or financial professional. In that case, where should you start?

The good news is that rolling your own portfolio doesn’t have to be complex. In fact, you can put together a completely serviceable portfolio by answering two relatively simple questions and buying three funds.

Stocks vs. bonds?

The first question that you’ll need to answer relates to your preferred stock/bond allocation. When considering this, you might be interested in reviewing the historical performance of various stock/bond allocations.

The upshot is that increasing your equity allocation increases your expected returns, though it also results in greater variability. In other words, your highs may be higher, but your lows will likely be lower.

Conversely, increasing your bond allocation (to a point) reduces risk, though that comes at a cost. I say “to a point” because, at the extreme, adding a small amount of stocks to an all-bond portfolio actually increases return while reducing risk.

Diversification ftw!

Domestic vs. international?

Once you’ve decided on an appropriate stock/bond allocation, you need to decide on your preferred mix of domestic vs. international equities. Why should you bother with international equities? For the diversification benefit.

If you look at historical data, you’ll find that the inclusion of international equities has the potential to increase returns while simultaneously reducing volatility. As with the addition of stocks to an all-bond portfolio, this is a classic win-win.

It’s also worth keeping in mind that the US stock market account for just about one-third of the world’s total market capitalization. That being said, you probably don’t want to go overboard with the international equities.

Most recommendations say that 20-40% of your equity allocation should be international stocks. As for us, we’re more or less splitting the different at two-thirds domestic, one-third international.

Assembling your portfolio

Once you’ve decided on your preferred stock/bond allocation as well as your split between domestic and international equities, it’s time to assemble your portfolio. Here’s a simple example…

Let’s say that you, like us, have settled on an overall 60/40 allocation. Let’s further assume that you’d like one-third of your equites to be international. In that case, a simple three fund portfolio would look something like this:

  • 40% total stock market
  • 20% total international stock market
  • 40% total bond market

Pretty simple, right? This is a great starting point, and you can tweak it from there. For example, some might prefer a short-term Treasury fund instead of a total bond market fund. Other might want to subdivide the bonds to include TIPS, stretching the three fund concept to four funds.

In fact, we’ve done the latter, splitting the bond allocation into two-thirds total bond market and one-third TIPS. Please see “Inside Our Investment Portfolio” if you’d like further details.

Note that you can get very close to the allocation listed above with something like the Vanguard LifeStrategy Moderate Growth Fund (VSMGX). That is, however, a static portfolio, so you’re locked into a single allocation over time. Moreover, you’ll also lose the ability to choose the location of your different asset types.

Speaking of which…

Determining asset location

Once you’ve determined your overall allocation, you might want to give some thought to tax efficiency when it comes to deciding where to put the various funds. If your portfolio exceeds your tax-advantaged space, conventional wisdom says…

  1. Your bonds should go in a tax-advantaged account,
  2. Your international equities should go in a taxable account, and
  3. You should fill in around these with domestic stocks.

This is, for the most part, how we handle things — though I should note that our portfolio is large enough that we can’t fit our bond positions into our tax-advantaged accounts. Because of this, we’re holding some tax-exempt (municipal) bonds on the taxable side and all of our equities are likewise being held in taxable accounts.

Specific fund choices

To give you a head start on fund selection, here are the ticker symbols for appropriate index funds from several major fund families. I’ve listed these in the following order: domestic equities, international equities, bonds.

You can, of course, use ETFs — e.g., VTI, VXUS, and BND, or the equivalents from other fund families — in place of mutual funds if that’s what you’d prefer. And if you’re in the Thrift Savings Plan, you can assemble a portfolio similar to the above using the C fund, I fund, and F (or G) fund.

Last but not least, we’re using VIPSX for our TIPS allocation and VWITX for our tax-exempt bond holdings. Note that I’ve listed the regular (investor) ticker symbols for the Vanguard funds above, though we’re actually holding the less expensive Admiral shares wherever possible.

Maintaining your portfolio

Finally… Once you have everything dialed in, you’ll just need to check back periodically to make sure it doesn’t get too far out of whack. If/when things drift outside your comfort zone (or at specified intervals, whatever you prefer) you’ll need to rebalance your portfolio to bring things back into line.

Protip: You can reduce your need to rebalance by directing new money (and/or dividend reinvestments) into whichever asset class is low vs. the target.

Now… That wasn’t too hard. Was it?

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