How To Create A 3-Fund Portfolio

Making sure you set money aside for retirement regularly is hard enough. Add in the fact that investing your hard-earned money may seem complicated, and it’s easy to understand why 43% of millennials have less than $5,000 invested for retirement.

However, the alternative to managing your own retirement portfolio is paying fees for someone else to do it. If you have absolutely no desire to control your own wealth, it may make sense to outsource it.

On the other hand, if you are hoping to accumulate as much money as possible, you’ll want to go the DIY route, since those advisory fees, paid year after year, can make a big dent in your wealth. Thankfully, the 3-Fund Portfolio might be the perfect way to invest if you want to keep things simple, low fee and highly effective.

What Is A 3-Fund Portfolio?

A 3-Fund Portfolio is simply an investment portfolio comprised of only three assets, which are typically low-cost index funds. It is a type of lazy portfolio since it requires very little maintenance on your part.

This means that you can spend less than a couple of hours annually to monitor and adjust your portfolio. That’s a small inconvenience for avoiding the cost of having someone else manage your portfolio for you.

What Is Inside A 3-Fund Portfolio

A 3-Fund Portfolio includes stocks and bonds via three index funds. Typically, a U.S. stock index fund, an international stock index fund, and a U.S. bond index fund.

You’ll want to find index funds with low expense ratios so that you can keep your costs low. An expense ratio refers to the annual fee charged by a fund, quoted as a percentage of assets managed.

You won’t be picking individual stocks for this strategy, which is why a 3-Fund Portfolio is so simple. By not picking individual stocks, you’re guaranteed to earn the average market return; something the majority of professional money managers are not able to do consistently.

Note that you can also create a 3-Fund Portfolio using exchange traded funds (ETFs), instead of regular index mutual funds if you prefer.

Asset Allocation

Deciding on how to allocate your investments across the three funds is the most nuanced part of creating a 3-Fund Portfolio. There is no one-size fits all approach. The most important consideration when it comes to asset allocation is your appetite for risk. How much risk are you comfortable taking? If you are in the beginning of your career, you may be willing to take more risk than you would on the eve of your retirement.

In general, the amount of bonds that you include in your portfolio will determine how volatile your portfolio will be. If you are nearing your retirement, or have a lower appetite for risk, you’ll want to include more bonds in your 3-Fund Portfolio.

The late Jack Bogle, founder of mutual fund giant Vanguard, suggested in The Little Book Of Common Sense Investing that younger investors hold 20% in bonds and 80% in stocks. He recommended increasing the share of bonds to 30% for those who are 45 and older. Finally, for those already retired, 40% or 50% in bonds is more appropriate, he wrote.

If you look at Vanguard’s target date funds for guidance, you’ll see a similar pattern. The Vanguard target date fund for an expected retirement date of 2050 holds only 10% in bonds, while the 2025 retirement fund includes 38% bonds.

However, you may want to include more or less bonds in your portfolio. Just remember that over a long investment horizon, your expected returns will be lower with bonds than stocks. It’s the price you pay for less volatility.

Once you’ve decided on your proportion of bonds, you’ll want to choose your split between U.S. and international stocks. Again, this is a personal decision. If we again look at Vanguard for guidance, its 2050 target date fund allocates 54% of its money to U.S. stocks and 36% to international stocks. In the 2025 fund, the split is 37% U.S. stocks, 25% international stocks and the remainder in bonds.

In both cases, Vanguard includes more U.S. stocks than international stocks.

Popular Index Funds

Choosing which index funds to select is simple if you focus on a couple key characteristics. You’ll want to keep your costs as low as possible, and your investments diversified and broad.

For example, an index fund with no fees but that is only comprised of technology stocks is not a good candidate for a 3-Fund Portfolio, since it only meets one of our criteria (low fees). An S&P 500 index fund with an expense ratio of .75% is also not a good choice, because of the high fees, even though it is a broad, diversified fund.

In terms of fees, you’ll want to look for funds with the lowest expense ratios possible. A solid expense ratio is 0.15% or lower. That’s 15/100ths of a percent. An expense ratio of 0.05% or less is considered best in class.

When it comes to diversification, you’ll want to look for a total stock market or S&P 500 index fund for stocks. By doing so, you’ll be buying a large set of stocks in a single investment, which will insulate you from the fluctuations of individual stocks. As long as the broad market gains, you’ll gain, regardless of the fluctuations of individual stocks.

For bonds, you’ll want a total bond market fund comprised of investment grade bonds.

Diversifying doesn’t mean that you’ll never lose money, since the entire market can and has dropped. It just means you’ll likely lose less than if you were to pick individual stocks.

Some index funds that meet this criteria are below.

Stock Index Funds

Bond Index Funds

If you have a preferred index fund that isn’t on this list, but is diversified and low cost, it may still be a solid option. These are simply the ones that embody our criteria well. It’s important to do your due diligence before making any investment. You’ll find more fund examples that fit the 3-Fund Portfolio here.

Maintenance

Once you’ve established your three fund portfolio, whether it’s a part of your 401(k), IRA, or taxable investment account, you’ll want to make sure you continue to contribute regularly. The only thing you need to do to manage your account is check your split between the three investments to make sure it reflects your risk appetite.

For most investors, checking this allocation annually is sufficient.

The 3-Fund Portfolio is beautiful in its simplicity and effectiveness, and is a great way to manage your own portfolio.