By Eric Rosenberg, WCI Contributor
Whether you’re new to investing or an investment veteran, you may be interested in building a streamlined portfolio with only a few investment funds. A three-fund portfolio could be all you need to reach your long-term investment goals. While diversification with more funds can be tempting, there’s often overlap when comparing large mutual funds and exchange-traded funds (ETFs). Here’s a look at a few approaches you can take to create a three-fund portfolio.
What Is a 3-Fund Portfolio?
As the name suggests, a three-fund portfolio is an investment strategy relying exclusively on three different funds, such as mutual funds or ETFs. While it may seem counterintuitive to own only three investments—whether in a specific investment account or across your entire portfolio—it’s actually quite logical for many investors.
Professionally managed active investment funds rarely beat a broad index fund, and low-cost S&P 500 funds tend to perform very well over many years and decades. Similar to professional investors who have fancy degrees and often spend 50+ hours a week investigating different investments, you may struggle to beat the market, whether picking a mix of stocks or funds. When you simplify your approach, you can mimic market performance while managing your risk with a few different funds. That’s potentially a big win for your finances.
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3-Fund Portfolio Pros and Cons
Pros
- Fewer investment decisions to make when building your portfolio
- Only three mutual funds or ETFs to keep track of long-term
- Options to quickly and easily adjust your portfolio
Cons
- Less fine-tuned control over your investments
- Poor performance from one of your funds can have an outsized impact
- Potentially less diversification, depending on the funds you choose
Picking Your 3-Fund Portfolio Allocation
Some self-proclaimed “Bogleheads”—fans of John Bogle, the index-fund pioneer who founded Vanguard—argue that a single investment in the Vanguard Total World Stock Index Fund ETF (VT) is a solid portfolio strategy. The fund basically gives you exposure to every publicly traded stock in the world. It’s market-weighted, meaning you get a larger portion of your portfolio placed into large stocks and a smaller portion in smaller companies.
That’s a little too streamlined for me, as I want a mix of stock and bond exposure. That leads us to the different potential investment categories you can choose.
- Stocks: Also called equities, stocks represent a sliver of ownership in the underlying company.
- Bonds: Bonds are a type of debt instrument where investors loan money to companies and governments in exchange for interest.
- Cash and cash equivalents: Cash is basically money in the bank. Cash equivalents include highly liquid bonds, including certain short-term government and business bonds.
- Alternatives: This broad category covers everything else. Commodities, real estate, precious metals, foreign currencies, and cryptocurrencies may all be considered alternative investments. Fine art, wine, and more could be part of someone’s alternative investments.
For many years, portfolio managers suggested most investors divide up their assets among stocks, bonds, and cash, with higher risk when younger and slowly lowering risk by shifting from stocks to bonds and increasing cash as they near retirement. Depending on your personal risk tolerance and investment goals, the mix of those categories varies.
But keep in mind that not all funds are exclusively focused on a single asset class. Some funds offer a mix of stocks, bonds, and other assets. With that in mind, you can easily whittle down your investment list to three funds covering a diverse mix of the assets you desire most.
I’d probably choose roughly 80% stocks, 15% bonds, and 5% alternatives for my age and investment risk.
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The Best Funds for a 3-Fund Portfolio
Now it’s time for the contenders. While there’s no perfect answer for everyone, here’s a look at several potential fund choices that could fit into a three-fund portfolio.
Stocks
For US stocks, you may want to consider total US market funds or more targeted funds, such as an S&P 500 index fund or Russell 2000 index fund. The fund you choose may depend on where you’re investing and its potential fees.
For total US stock market funds, we like funds including VTI (Vanguard Total Stock Market Index Fund ETF) and VTSAX (The Vanguard Total Stock Market Index Admiral Shares) from Vanguard. Fidelity, Schwab, and iShares all offer compelling versions of a total US market index fund with low fees.
An S&P 500 index fund could also suit you well. Again, top market players such as Vanguard, Fidelity, Charles Schwab, and Blackrock iShares compete in this market. Aside from fees and mutual fund vs. ETF formats, they’re all basically the same.
Not all investors need to worry about non-US stocks, but if you’d like to diversify your investments into the global economy, these same top investment companies offer index funds focused on the total world stock market. VT from Vanguard is a standout in this space. As the Bogleheads say: VT and chill.
Bonds
For bonds, the main divisions most US investors should look at are corporate bonds and government bonds. Corporate bonds are loans to companies, and most large corporations can easily pay back their debt over the time horizon of the bond. With a diverse bond fund, you can gain exposure to large companies with good credit ratings or a mix of bonds, including riskier firms.
Federal government bonds are typically extremely safe but pay lower interest rates. Municipal bonds offer unique tax savings, which could make them desirable.
Here, indexed bond funds can be a good choice for low-fee investing. You might also consider more actively managed bond funds, such as the American Funds Bond Fund of America (ABNDX) or BlackRock High Yield Bond (BHYIX), to get more strategic bond ownership.
Alternatives
For alternative investments, you have plenty of options. Depending on your goals and market expectations, a real estate or precious metals fund may fit. But with a slim portfolio of only three funds, you might skip alternatives completely.
What About Target Date Funds?
Target date funds offer an interesting option as well. Target date funds are managed funds where a team of professional investors keeps your investment account balanced for someone with a specific target retirement date.
BlackRock launched the first line of retirement date fund ETFs—called iShares LifePath funds—where you can arguably invest with a one-fund portfolio, even less than three funds. If you’re looking at mutual funds, the same big players offer target date funds with dates spaced out every five years.
In most cases, these funds will mix stocks, bonds, and cash using other ETFs as underlying investments. If the fees and portfolio mix makes sense, target date funds could make up a significant portion of a three-fund portfolio.
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How to Create a 3-Fund Portfolio: The Bottom Line
We can’t tell you exactly how to structure a three-fund portfolio, but it’s a good strategy for many busy medical professionals who want to set their investments and leave them on autopilot for decades until they retire. They’re not perfect for everyone, but if you’re less confident picking a complex mix of stocks and funds, the three-fund portfolio could perfectly fit your unique investment goals and needs.
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