The Simple Magic of Investing in a Three-Fund Portfolio

Occam’s razor is the idea that a simpler solution is more likely to be correct than a complex one.

In investing, Occam’s razor is usually 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 and hedge funds. Most famously, there was the $1 million bet between a co-manager at Protégé Partners (a hedge fund) and Warren Buffett.

The bet was that a fund of five hedge funds could beat the S&P 500 over ten years… SPOILER ALERT! It did not.

(and it lost by a very wide margin)

There are many reasons why passively managed index funds beat actively managed funds.

But there are also quite a lot of them. Looking at some of the most popular Vanguard funds, you’ll see both Total Stock Market and the 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 itself), you may not know the name Taylor Larimore.

Taylor Larimore is widely considered the “dean” of the Bogleheads and he is the 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 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 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 (here’s a longer article on the differences between ETFs and mutual funds). They’re functionally the same and ETFs may be a little cheaper sometimes.

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)

It’s important to note that you usually want total market funds as your domestic stock market fund; you don’t want to invest in an S&P 500 index because that’s slightly narrower in scope.

Here are the differences between VOO (S&P 500 Index) vs. VTI (Total Market).

How do I set my allocation?

Great question!

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% in stocks and 20% in bonds.

In his book, Larimore 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” Portfolios

The three-fund portfolio is the more famous “lazy portfolio” 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 the 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 comprises the three-fund portfolio plus a Vanguard REIT Index Fund (VGSLX).

Then there’s the ever-popular Ray Dalio All-Weather Portfolio that offers a different approach – an asset allocation seeking a positive return in all types of markets. This one is less “lazy” than others as it has a mix of five asset classes:

• 30% in U.S. stocks
• 40% in Long-term U.S. Treasury Bonds
• 15% in Intermediate-Term U.S. Treasury Bonds
• 7.50% in Gold
• 7.50% in broad Commodity basket

As you can see, most are pretty simple, elegantly lazy, and have fun names.

Still Too Complicated? Pick a Target Date Fund

Target date funds are mutual funds that will adjust their investment mix as the years pass. They are targeting a specific retirement year so the allocation will shift as you near retirement. Vanguard has Target Date funds (with a specific date) and LifeStrategy Funds (without specific dates). Each brokerage has similar funds.

The Vanguard Target Date funds are dated every five years and they’re essentially four fund portfolios:

1. Vanguard Total Stock Market Index Fund Institutional Plus Shares
2. Vanguard Total International Stock Index Fund Investor Shares
3. Vanguard Total Bond Market II Index Fund
4. Vanguard Total International Bond II Index Fund

Does that mix look familiar? Each target date fund has a different allocation mix.

The TDF 2070 (VSVNX) has this allocation:

1. Vanguard Total Stock Market Index Fund Institutional Plus Shares – 54%
2. Vanguard Total International Stock Index Fund Investor Shares – 36%
3. Vanguard Total Bond Market II Index Fund – 7%
4. Vanguard Total International Bond II Index Fund – 3%

The TDF 2050 (VFIFX) has this allocation:

1. Vanguard Total Stock Market Index Fund Institutional Plus Shares – 53.9%
2. Vanguard Total International Stock Index Fund Investor Shares – 36.20%
3. Vanguard Total Bond Market II Index Fund – 7.10%
4. Vanguard Total International Bond II Index Fund – 2.80%

One of the largest mutual fund companies in the world, with billions in assets under management in a dozen target date funds, uses a simple four-fund portfolio.

Do you really believe you need something more complex than that? 😁

Is It Really That Simple?

Yes. It really is!

The hard part is convincing yourself you only need three or four funds. We’ve all been conditioned to think that investing is complicated; you need lots of training and education, and you can’t do it yourself.

In fact, you may even be pausing to wonder if your S&P 500 index fund should be VOO or SPY! It doesn’t matter.

Some professions make more money when you think it’s complicated. (would you pay someone hundreds or thousands of dollars a year to put you in a target date retirement fund??? of course not!)

The more complicated way = more hands in your pocket.

Stockbrokers make money when you buy and sell stock on their platforms. Actively managed mutual funds take a little slice off the top of your investment, whether up or down on the year. Hedge funds take a small percentage of the total assets plus a bigger percentage of the gains. Advisors have to give advice, good or bad, or they don’t justify their fees.

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% annually. It’s actually cheaper if you go with VTI, the ETF version and its 0.03% fee. You can even buy and sell shares for free.

For every $1,000 you invest, you pay forty cents. FORTY CENTS.

It’s no wonder that Vanguard has trillions of assets under management. And why every major mutual fund company, like Fidelity and Schwab, have a similar product with a similar expense ratio.

(Thanks Jack!)

That’s why the hardest part is believing you only need a handful of funds to save for retirement.