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The 3 Fund Portfolio: The Ultimate Guide for Beginners

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The 3 Fund Portfolio

In this post we’ll cover everything you need to know about the so-called 3 fund portfolio.

By the end of the post you’ll know:

  • exactly how to acquire it depending on your age and your country, like US or Europe,
  • all the benefits of this portfolio,
  • how it performed in the past
  • how to rebalance it every year with a free Tool I’ll give you

If there is one thing that I love about investing in the stock market is that you don’t need to be a genius to perform better than most people. In fact, the simpler you keep your investing style, the higher the results you’ll get.

Active Fund Managers have been trying to perform better than the S&P500 for decades, but never managed to be successful in the long term. And this is why with 3 simple investments of the 3 fund Portfolio, without any effort or complication, you will perform better than almost 80% of active fund managers.

Part 1 – Overview

While most people put so much effort trying to find the best stocks to buy using complicated tables and reading through news and financial statements, using the three fund portfolio you’re going to get the best diversification and final return by using just 3 broad-based index funds that cover both the stock and the bond market.

You’re going to have a fund that covers the U.S. stock market, a fund that covers the International stock market, and a fund that covers the bond market.

The U.S. Stock Market is going to be the part that will give you the highest growth, the International Market will give you a higher diversification – because you’re not only dependent on the success of one single country – and the bond market is your safe section. Basically, safe bonds that will give you some safe cash flow and should actually keep a stable price over time.

The biggest advantage that you have through this diversification is a stable growth that doesn’t look like a rollercoaster because of market downturns.

As an investor, your biggest enemy is not the stock market, but your emotions. The main reason why earning money in the stock market is so hard is because each time a stock goes down 30, 40, sometimes 50%, it’s hard to see your whole net worth cut in half and do nothing.

That’s why a mix of stocks and bonds, diversified with national and international markets, is the best way to give you peace of mind and avoid making costly mistakes.

Part 2 – Benefits of the 3 fund portfolio

Let’s talk about the 5 main benefits of the 3 fund portfolio. 

Benefit 1 – It’s simple

The first is that it’s simple. You only buy 3 funds and suddenly you own over 22,000 different securities worldwide in the stock and the bond market, without overlap amongst your investments. You don’t have to think about how much to allocate in each sector because the funds do it for you. So no more headaches, no more paradox of choice between thousands of different stocks or index funds, and still an above average performance.

Benefit 2 – It’s diversified

The second benefit is the great diversification. When it comes to diversification all the great investors seem to have different ideas but in reality they are spreading the same message.

Ray Dalio, for example, says that diversification is the Holy Grail of Investing because it protects you in every phase of the market cycles:

Warren Buffett instead said that “Diversification is protection against ignorance, and makes little sense if you know what you’re doing.”.

But if you reflect on these two statements, you actually find them to say exactly the same thing: If we are not incredible investors like Ray Dalio or Warren Buffett, with all the resources and knowledge they have, can we really be so presumptuous and believe we can do better than most investors? Most hedge funds can’t beat the market, so you realize that, most likely, we are not going to.

Benefit 3 – It’s cheap

The third benefit of the 3 fund portfolio is the cost. The average expense ratio of these funds is going to be around 0.05% to 0.1%. That means that every year, for a 10,000$ portfolio, you’re going to pay between $5 and $10 of fees on average.

If we assume to invest $100,000 with a 4% annual return and we let it compound yearly, we can calculate how our portfolio grows if it has an ongoing fee of 0.05%, 0.5%, or 1%:

Effect of Expense Ratio on $100,000 invested over 20 years with 4% Rate of return – Source: Author

Notice how the fees affect the Investment Portfolio over 20 years. Between 0.05% and 0.5% expense ratio you have a loss of around $20,000, while between 0.05% and 1% the loss over the same period would be almost $40,000.

Since the three fund portfolio is going to be composed of funds with the lowest expense ratios possible, you’re going to save thousands and thousands of dollars just thanks to that.

Benefit 4 – there is no financial advisor fee

The fourth benefit is that there’s no financial advisor fee. Financial advisor fees are usually high and will eat into your returns, but in this portfolio strategy, you’re only going to be investing in passive index funds.

Benefit 5 – it never underperforms the market

The fifth and the most important benefit of the three fund portfolio is that it never underperforms the market, as opposed to most active fund managers. Since it’s tracking the broader market, you are putting your money into most of the stocks and bonds that exist in the world. And as I showed at the beginning, most studies prove that most active fund managers usually underperform the market.

This chart shows for example how the average Hedge Fund performed compared to the S&P500, and they actually underperformed every single year from 2011 to 2020:

So these are the 5 most important benefits of the three-fund portfolio. Now let’s see how to construct the portfolio.

Part 3 – The Three Funds

The Three Funds – ETF US

In this part of the video you’ll see which funds you need to invest in depending on the brokerage you have and on the country you live in.

Three Fund Portfolio based on brokerage

Here’s a graph I made that shows you where you can invest based on the brokerage you use. As you can see, you can buy ETFs or Index Funds.

ETFs are usually lower cost and more tax-efficient than Index Funds and can be traded throughout the day like stocks.

If you buy ETFs, you’re going to need VTI, VXUS and BND. VTI is the Vanguard Total Stock Market Index Fund ETF and covers the whole American Stock Market. VXUS is the Vanguard Total International Stock Index Fund ETF, and covers the international Market, and BND is the Vanguard Total Bond Market Index Fund ETF, which covers the bond market.

You can buy these on any brokerage in the US, like Robinhood, M1-Finance or Webull. 

The Three Funds – ETF Europe

Three Fund Portfolio based on brokerage – ETF Europe

If instead you live in Europe, you need a European equivalent. ETFs in Europe trade under the so-called UCITS, which is the main European framework for investments like ETFs or Index Funds. In Europe you can use for example Trade Republic, Degiro or Scalable Capital as trading apps.

In Europe you’re not going to have all the choices that you have in the US, but let’s see what the equivalents are.

The closest UCITS equivalent to VTI ETF is the Vanguard S&P 500 UCITS ETF (LON:VUAA). Vanguard S&P 500 includes the 500 best companies in the US and not the whole American Stock Market. However, since both indices are weighted by market size, the performance is almost the same.

Now, moving to VXUS, there isn’t exactly an ETF in Europe that tracks the same index. However, since your goal with these first 2 ETFs is to create a global portfolio with an overweight in the US, you can achieve it by picking an all world fund like the Vanguard FTSE All-World UCITS ETF or the iShares MSCI ACWI UCITS ETF along with the S&P 500 fund I told you before.

As for BND, the Bond Index, you should go for the iShares US Aggregate Bond UCITS ETF. This tracks the same index as BND, which covers the American Bond Market. If instead you want to track the whole bond market instead of only the US market, you can go for the iShares Core Global Aggregate Bond UCITS ETF.

The Three Funds – Index Funds

Three Fund Portfolio based on brokerage – Index Funds

Moving to the index funds, you can see that if you have a specific brokerage open, like Vanguard, Fidelity or Schwab, there are specific index funds that you can buy as well. So with Vanguard, you can buy VTSAX, which is the total stock market index, VTIAX, which is the international market index fund, and VBTLX, which is their bond market index fund.

Fidelity offers index funds with zero fees, which is great, so if you invest with them you’re going to need the FZROX for the American Stock Market, FZILX for the international stock market and FXNAX for the bonds.

For Schwab, you can get SWTSX, SWISX, and SWAGX.

Some of the index funds will have minimum investment requirements. If you want to avoid that, you can always go for the ETFs.

Part 4 – Historical Performance

Let’s take a look into some historical data and see how these different asset allocations perform. Since the 3 fund portfolio is often recommended by Bogleheads, which is a community of investors which are fans of Jack Bogle, the founder of Vanguard, in their forum there is someone that has been updating the results of the portfolio every single year and here’s the results from 1997 to 2022 in four different cases:

Results of the 3 Fund Portfolio with different compositions, 1997 – 2022 – Source Bogleheads

80/20 means 80% in stocks and 20% in bonds, and so on down to 20/80 for 20% stocks and 80% bonds.

For the most part the years are positive and, depending on the asset allocation between stocks and bonds, you’d have had between 1997 and today an annual average return between 5% and 8% (See first line, the average).

Not every single year is going to be a positive year for your portfolio, but still, whatever attempt you’d make to try to buy or sell stocks or ETF to avoid these downturns would most likely lead you to a lower performance.

Since I don’t want you to lose faith in the Stock Market only because it went down in 2022, here’s a great chart from JPMorgan that shows the yearly returns of the american stock market from the 80s to today:

Annual returns and intra-year declines – Source: JP Morgan

You can see that despite some bad years with an average drop of 14.3%, the annual returns have been positive for most of the time.

Part 5 – % Asset Allocation

How much you should allocate in each one of these funds depends on a few factors like your risk tolerance, your goal, your time horizon for your investment and your age.

In general, as you could see from the performance table I showed you before, an overweight in stocks will give you a better return in the long term but will also cause bigger ups and downs because it’s more volatile. 

So risk tolerance is surely the main factor here. 

The common rule of asset allocation by age is that you should hold a percentage of stocks that is equal to 100 minus your age. So if you’re 40, you should hold 60% of your portfolio in stocks. Since life expectancy is growing, though, I’m going to change the rule to 110 minus your age.

But the truth is, you really need to decide by yourself based on how much downside you can stomach in bad market times. From here you can get for free the google sheets table that I created, that will allow you to see the historical results of the 3 fund portfolio since 1997 in all main different allocation. In the same file you’ll also find the tool for rebalancing your portfolio every year, but we’ll talk about that later.

In terms of the most common asset allocations for the three-fund portfolio, here are the most common, that you can find in www.bogleheads.org:

Three Fund Portfolio – 80 / 20 – Aggressive – Source: Bogleheads and redesigned by Rick Dago

from the most aggressive to the most conservative, the first one is an 80/20 portfolio and it will consist of 64% U.S. stocks, 16% International stocks and 20% bonds.

Three Fund Portfolio – 60 / 40 – medium Aggressive – Source: Bogleheads and redesigned by Rick Dago

Less aggressive is the 60/40, with 48% US, 12% International and 40% bonds.

Three Fund Portfolio – Equal portfolio – Source: Bogleheads and redesigned by Rick Dago

Then an equal portfolio would have 34/33/33, although I would always prefer to have more weight in the US Stock Market than the international.

Three Fund Portfolio – 40 / 60 – Conservative – Source: Bogleheads and redesigned by Rick Dago

Then we have a conservative 40/60 Portfolio with 32% US, 8% international and 60% bonds,

Three Fund Portfolio – 20 / 80 – Overly Conservative – Source: Bogleheads and redesigned by Rick Dago

as well as an extra conservative 20/80 Portfolio, with 14% U.S. stocks, 6% International stocks and 80% bonds.

To make it simple for you, in the free tool that you’ll find in the description I created a table that gives you the exact percentages based on your age. 

You might be wondering why we are not 50/50 in terms of U.S. stocks versus International stocks, and the reason is that International stocks are considered more volatile and add complexity because of the currency exchange. In addition, a lot of international markets aren’t as developed as the United States, so you’ll see that the international market so far has performed less than the US. Nevertheless, you shouldn’t put all your eggs in the US basket, and that’s what the international market is for.

Part 6 – Rebalancing

Alright, now we got to the last part of this video which is by the way one of the most important. Rebalancing your portfolio every year is important because the three funds are going to give you different returns, so if you start for example with an 80/20 allocation, after one year these percentages are going to be different and should be adjusted.

So let’s say that you start with an 80/20 portfolio and you invest $10,000. At the beginning you’re going to have $6,400 in US Stocks, $1,600 in International Stocks and $2,000 in Bonds.

Original Allocation – Screenshot of Rebalancing Tool by Rick Dago – Download for free from here

Now after one year you want to rebalance and you notice that the US stocks have performed much better and you find yourself, let’s say, with $8,000 in US Stocks, $1,700 in International stocks and $1,800 in Bonds:

Sample Allocation after 1 year – Screenshot of Rebalancing Tool – Download for free from here

Through the tool I’m giving you, calculating how to rebalance is going to be really easy. You just need to fill in the orange cells. First of all, as we’ve seen before, you can write your age in the cell B6 and the tool gives you the suggested allocation in the line 10 “Suggested allocation”:

Inserting your age – Screenshot of Rebalancing Tool – Download for free from here

In the line “Your desired allocation” you can write a different allocation than the suggested one, if you want. For the sake of this example let’s assume you want the same, so just write here 64%, 16% and 20%.

Inserting your desired allocation- Screenshot of Rebalancing Tool – Download for free from here

In the portfolio value you write exactly how much you possess now in your portfolio and in our example it’s going to be $8,000 in US Stocks, $1,700 in International stocks and $1,800 in Bonds:

Inserting your Portfolio Value – Screenshot of Rebalancing Tool – Download for free from here

So, as you can see, your current allocation is not right anymore, and here you see exactly what you need to sell and what you need to buy of the three funds:

How to rebalance – Screenshot of Rebalancing Tool – Download for free from here

In particular, in this case you must sell $640 of the US Stock Market Fund and buy $140 of the International Stock Fund and $500 of the Bond Fund. If you do so, in the last yellow line you’ll see your final result and, as you can see, you’ll get back exactly to the desired allocation of 64/16/20.

Now, rebalancing doesn’t mean you’re withdrawing money from your Investment Portfolio, and if you do a rebalance within a tax advantaged account like the 401K or even the Roth IRA, you might not even pay taxes on that until way later.

Conclusions

The 3 Fund Portfolio is a simple, yet powerful investment strategy with a lot of benefits. You’ll be able to achieve a better performance than most of hedge funds and active fund managers in the long term, while simplifying your investment strategy in an incredible way.

By diversifying your investments across three key asset classes—U.S. Stocks, International Stocks, and Bonds—you can significantly reduce risk while potentially maximizing returns.

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