Occam's razor is the idea that the simpler solution is more likely to be correct than complex solutions.
In investing, Occam's razor is right. Simple is better.
And in this case, simple means a handful of passively managed index funds.
Over the long run, index investing has beaten actively managed funds as well as hedge funds. Most famously, there was the $1 million bet between a co-manager at Prot√©g√© Partners (a hedge fund) and Warren Buffett.
The bet was that a fund of five hedge funds could beat the S&P 500 over 10 years… SPOILER ALERT! It did not.
(and it lost by a very wide margin)
There are a lot of reasons why passively managed index funds beat actively managed funds.
But there are also quite a lot of them. If you look at some of the most popular Vanguard funds, you'll see both Total Stock Market and S&P 500. What's the difference? Do you need them both? What's the mix?
Fortunately, it's even simpler than that.
You can build a great diversified portfolio with just three funds.
What is the Three Fund Portfolio?
Unless you're a big fan of Vanguard, Jack Bogle (founder of Vanguard), or are a Boglehead (huge fans of Vanguard), you probably don't know who Taylor Larimore is.
Taylor Larimore is considered the dean of the Bogleheads and author of several books, one of which is titled The Bogleheads' Guide to the Three-Fund Portfolio.
I think it's safe to say that he's the originator of the idea of a three-fund portfolio, most recently captured in this post on the Boglehead forums in 2012. The three-fund portfolio is one of the most popular portfolio setups among Bogleheads for its diversification and its simplicity.
A three-fund portfolio consists of:
- Domestic stock “total market” index fund
- International stock “total market” index fund
- Bond “total market” index fund
You can get these funds from anywhere but the three Vanguard funds that fit this approach are:
- Vanguard Total Stock Market Index Fund (VTSAX)
- Vanguard Total International Stock Index Fund (VTIAX)
- Vanguard Total Bond Market Fund (VBTLX)
Sometimes, people will talk about a four-fund portfolio. That's a three-fund portfolio plus an international bond component, like the Vanguard Total International Bond Index (VTABX).
I list Vanguard mutual funds but you can invest with exchange-traded funds (ETFs) too. They're functionally the same and ETFs may be a little cheaper.
The ETFs are:
- Vanguard Total Stock Market ETF (VTI)
- Vanguard Total International Stock ETF (VXUS)
- Vanguard Total Bond Market Fund (BND)
- Vanguard Total International Bond Index (BNDX)
How do I set my allocation?
I think there's no better answer than to fill out this 12-question investor questionnaire from Vanguard.
Alternatively, you can use the very simple 120 minus your age as the stock percentage. A 40-year-old would put 80% stocks and 20% bonds.
Larimore, in his book, offers the rule that you should hold your age in bonds. So, a 40-year-old would put 60% stocks and 40% bonds.
That will tell you the percentage of stocks and bonds. Larimore, and Vanguard research on international equity, suggests a 20% international allocation where you can decide how much international exposure you'd prefer, but from there the math is easy.
If you were given an 80% stock, 20% bond and wanted to have a 20% international allocation, this is how'd you invest into the three funds:
- Total Stock Market (VTSAX) – 64%
- Total International Stock (VTIAX) – 16%
- Total Bond Market Fund (VBTLX) – 20%
Other “Lazy” Porfolios
The three-fund portfolio is one of the more famous “lazy portfolios” but you've probably heard of others like Scott Burns' Couch Potato portfolio or Rick Ferri's Lazy portfolio or his “Core Four” portfolio. They're great names but fundamentally the same idea – a small number of low-cost index funds with minimal (or no) overlap.
Scott Burns' Couch Potato is an even split of Vanguard Inflation-Protected Securities Fund (VIPSX), Vanguard Total Stock Market Index Fund (VTSAX), and Vanguard Total International Stock Index Fund (VTIAX).
Rick Ferri's Core Four consists of the three-fund portfolio plus a Vanguard REIT Index Fund (VGSLX).
As you can see, most are pretty simple, elegantly lazy, and have fun names.
The hard part is convincing yourself you only need three or four funds. We've all been trained to think that investing is super complicated, you need a ton of training and education, and you can't do it yourself.
Some people make more money when you think it's complicated.
The more complicated way = more hands in your pocket.
Stockbrokers make money when you buy and sell a stock. Actively managed mutual funds take a little slice off the top of your investment, whether it's up or down on the year. Hedge funds take a small percentage of the total assets plus a bigger percentage of the gains.
Everyone is making money off your money.
Then you have a guy like Jack Bogle, founder of Vanguard, who says you can get the entire S&P 500 index (VTSAX) and pay just 0.04% a year. You can even buy and sell shares for free.
For every $1,000 you invest, you pay forty cents. FORTY CENTS.
That's why Vanguard has trillions in assets under management. And why every major mutual fund company, like Fidelity, also has a similar product with a similar expense ratio.
And all you need are a handful of funds to save for retirement.