Three-Fund Portfolios Can Cut Risk, Taxes, and Costs for Investors. Here’s How to Build One.

It consists of three index mutual funds or exchange-traded funds–a U.S. total stock market fund, an international stock fund that invests in both developed and emerging markets, and a broad U.S. bond fund. How savings are divided among the three funds will depend on an investor’s age, goals, preferences, and risk tolerance. The combined portfolio requires little upkeep with the exception of occasional rebalancing.

Low Costs and Broad Exposure

“The primary benefits of the three-fund portfolio are its maximum diversification, very low cost, and simplicity for the investor, caregivers and heirs,” says Taylor Larimore, co-founder of the Bogleheads and author of The Bogleheads’ Guide to the Three-Fund Portfolio. 

Larimore, 97 years old, says he had an epiphany after reading Bogle’s first book on mutual funds in 1993. He realized that three total-market index funds “with over 15,000 individual U.S. stocks offered more diversification, lower costs, and greater tax-efficiency” than the “hodge-podge of 16 funds” he was holding at the time.

The three-fund strategy is suitable for investors of any age, Larimore says, and the three low-cost total market index funds needed to construct the portfolio could be purchased from Fidelity Investments, Charles Schwab, Vanguard Group or other large mutual fund companies.  One common low-cost version of the portfolio is composed of the Vanguard Total Stock Market Index Fund (ticker: VTSAX), Vanguard Total International Stock Index Fund (VTIAX), and Vanguard Total Bond Market Index Fund (VBTLX). 

But when using such simple strategies, investors should make sure they’re buying low-cost funds with broad exposure. ETF expense ratios vary widely depending on fund strategies, and even sector index funds aren’t necessarily low cost, says Victoria Greene, founding partner and portfolio manager at G Squared Private Wealth In College Station, Texas. “You have to be sure to do your due diligence on what you’re buying,” she says. 

Another risk with such a simple portfolio is that investors will set it and forget it. During a strong stock run, such as the one global equities have enjoyed in recent years, a three-fund portfolio could grow to be dominated by its core stock holdings, leaving an investor without sufficient cushioning from the stable income that bonds offer, Greene warns. Without rebalancing, she says, “you’re at risk that this simplicity is going to blow up on you.”  

David Blanchett, head of retirement research for Morningstar’s investment management group, says most large recordkeepers allow investors to set up automatic rebalancing at defined intervals. “You may not want to do that if it’s a taxable account, but if it’s a 401(k) or an IRA, you can set it up automatically,” he says.  

Adjusting the Strategy

Despite its simplicity, diversification, and low cost, the three-fund portfolio isn’t for every investor. Using such a cookie-cutter approach makes it more difficult to take advantage of specific market opportunities.  

In recent years, for example, owning strong-performing large-cap growth stocks versus weaker-performing large-cap value stocks has “made a massive difference in people’s portfolios,” Greene says. Investors who rigidly stuck to a three-fund strategy may have missed out on market-beating returns during that period. 

But it is possible to custom-fit a three-fund portfolio strategy by tilting it more toward stocks or bonds without trading it like a hedge fund, says Greene.  “Those who allocate more now to value and small-cap stocks, which have lagged recently, may do quite well over the next five years,” she says. “There’s a lot to be said for making sure your portfolio fits where market opportunities lie.”   

Investors can complement a traditional three-fund portfolio by adding stock funds or ETFs with exposure to parts of the market that look less frothy or undervalued, says Andrew Mies, chief investment officer and partner at 6 Meridian, an investment advisory firm in Wichita, Kan. They can also simplify the approach further by investing in just two funds, say a global stock fund and a world bond index fund, he says. 

Whether an investor owns a three-fund portfolio or a 30-fund portfolio, the worry is that they’ll want to time the market, Blanchett warns. “You can have a very diversified portfolio with a single investment or three or five as long as you’re using the right pillar holdings,” he says. “If not owning Apple is going to cause you to sell your portfolio, then that’s a problem.”  

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