One of the key questions of investing is, naturally, what exactly to invest in. You know it should be a mutual fund, right? And you’ve heard that “low cost” and “diverse” are good. But what does that actually look like? Spend a little time on personal finance message boards for help, and you’re sure to come across someone praising the practicality of the “three-fund portfolio.”
This type of investment portfolio was popularized by the Bogleheads, a group of superfans for Jack Bogle, the founder of the Vanguard Group and creator of the index mutual fund. Its thesis is this: You simply need to hold three different funds, covering three different asset classes, in your retirement account to retire wealthily.
The funds should be a total U.S. stock index fund, a total international stock fund and a total bond index fund, where “total” means it includes a wide range of equities, in the case of the stock funds, or bonds, getting you the most diversity for your buck. (It does not consider cash as an investing asset.)
“The total stock market fund covers large-cap, mid-cap and small-cap stocks, while the S&P 500 covers only the large-cap universe,” writes CNBC. The diversity makes it ideal for passive investors leaving their assets alone for a while, like, as noted above, in your retirement account. More active investors with different goals might consider something else. But for many of us, the hands-off approach works. Rather than listening to the investment industry, which has no shortage of new funds and tricks to try, you stick with what works.
Here are Vanguard’s funds that match up with the three-fund approach:
But you will find almost exactly the same funds at other providers, like the Fidelity Total Market Index Fund (FSTMX) or the Schwab Total Stock Market Index Fund (SWTSX). In fact, back in August of 2018, Fidelity announced that two of its first fee-free index funds are the Fidelity Zero Total Market Index Fund (FZROX), which has about 2,500 holdings, and the Fidelity Zero International Index Fund (FZILX), which “is designed to invest in the vast majority of the most valuable companies listed on international exchanges,” according to the Motley Fool (that said, they do not have the same holdings as the non-free version, natch, so you’ll want to compare on a site like Morningstar before purchasing). The differences between total index funds at different brokers, should there be any, are likely negligible.
For Bogleheads, the simplicity is the key. Rather than futzing with a bunch of different funds that give you exposure to different parts of the market, you pick three all-in-one funds and let them sit. “Funds like these are the closest thing to truly passive stock investing,” notes the Motley Fool. Another key: They are inexpensive to hold, both in terms of fees and taxes.
Once you’ve picked your three total funds, you decide your asset allocation from there. For example, you might hold the largest percentage of your money in the U.S. stock fund, followed by the international stock fund and then the domestic bond fund. How much of each to hold is hotly contested in the Boglehead forum, especially when it comes to international funds.
“In my book, I recommend that international stocks represent 20 percent of equity for U.S. investors,” Taylor Larimore, founder of the Bogleheads and author of The Bogleheads’ Guide to the Three-Fund Portfolio, told Marketwatch. “This is a compromise between what Jack Bogle recommends (zero to 20 percent) and what a Vanguard study recommends (20 percent to 40 percent). The problem is that no one knows in advance which will turn out to be the best road.”
If your 401(k) plan does not give you access to these funds, Larimore told Marketwatch that “a [S&P] 500 Index Fund is a good substitute.” It’s not as comprehensive, but it’s the next best thing.
Larimore explained the appeal in a 2012 post on the Boglehead forum:
* Avoids wasted time, confusion and the possibility of mistakes trying to pick the best of thousands of mutual funds and ETFs.
* Very diversified with over 15,000 worldwide securities (lower risk).
* Very low expense ratios.
* Very low (hidden) turnover costs.
* Very tax-efficient.
* The many Advantages of Simplicity.
* Fewer but larger funds results in earlier eligibility for low-cost Admiral shares.
* No adviser risk.
* No fund manager risk.
* No style drift.
* No asset bloat.
* No tracking error to cause abandonment of the strategy.
* No fund overlap.
* No front-running that reduces sub-index returns.
* Automatic rebalancing within each fund.
* Less worry. Never under-performs the market.
* Easy to maintain for the owner, spouse, caregivers and heirs.
* More free time.
Obviously, this isn’t the only way to invest, just one option with a big support network. To circle back around to an important point, these are otherwise known as “core” holdings. Once you have these, and you let them sit, you are, of course, free to add to them with other investments. But you want to make sure you’re contributing consistently to these core funds. Sometimes simplicity is all you need.