By Eric Rosenberg, WCI ContributorWhen choosing investments, it’s easy to get overwhelmed with trying to find the right combination of stocks, bonds, and alternatives for your portfolio. But complexity doesn’t necessarily mean success. In fact, there’s a strong argument that a simple portfolio made up of just three funds could outperform a portfolio of your favorite stocks.
Whether you’re new to the concept of a three-fund portfolio or have heard of the idea and want to find out if it could be right for your investment goals, here’s a more detailed look at how three-fund portfolios work and how to decide if it makes sense for your financial needs.
What Is a 3-Fund Portfolio?
As the name implies, a three-fund portfolio is an investment fund comprising just three mutual funds or ETFs. It’s ideal for new and less-experienced investors or anyone who wants to keep their investments simple while maintaining a low-cost portfolio aligned with their risk tolerance.
A three-fund portfolio typically includes a mix of these types of funds:
- Domestic stock fund
- International stock fund
- Bond fund
We’re generally partial to ETFs over mutual funds, but you can pick any combination of them to reach the typical goals of a three-fund portfolio investor. The percentage of your portfolio allocated to each varies based on your goals, and they may shift over time.
More information here:
Best Investment Portfolios – 150 Portfolios Better Than Yours
The Benefits of a 3-Fund Portfolio
A three-fund portfolio can be helpful for many doctors and other professionals. Here’s a look at the biggest benefits of a three-fund portfolio.
Diversification
While holding just three funds may not sound diversified, the funds you choose can lead to plenty of diversification through their holdings. For example, a total market ETF can expose you to more than 3,600 stocks from a single fund. With three ETFs, you could hold virtually every stock traded on major markets worldwide.
Of course, that means picking suitable funds, as many hold far fewer underlying investments. If you buy well, however, you can get plenty of diversification with just a few funds.
Low Cost
VTI, the Vanguard Total Stock Market ETF, charges just 0.03% per year, a very low cost for a cornerstone of many portfolios. IVV, the iShares Core S&P 500 ETF, similarly charges just 0.03% and gives you access to 500 of the biggest public companies in the United States. Some funds now charge no management fees, such as the Fidelity Zero family of funds.
While you may be tempted to pay more for professionally managed investment funds where the full-time managers pick and choose stocks, you’re usually better off with index funds. Not only do they charge lower fees, but about 80% of actively managed funds perform worse than their target benchmark index.
Simplicity and Ease of Management
When you pick three funds, you have a simple portfolio that’s easy to manage. You don’t have to check in on the news surrounding a specific stock. Instead, you can set it and forget it, knowing that your portfolio will generally follow economic and market trends.
You only have to worry about the weighting you choose between the funds, such as 60% stocks and 40% bonds. Changing your allocation only takes a few clicks on your computer or taps on your phone’s screen. And with just three holdings that you don’t regularly buy and sell, taxes are a breeze as well.
Components of a 3-Fund Portfolio
While no rule says you must model your holdings exactly this way, many investors choose the following categories when picking funds for their three-fund portfolios.
Domestic Stock Fund
A domestic stock fund is a mutual fund or ETF focused on stocks trading in the United States, primarily on the New York Stock Exchange or NASDAQ. For our purposes, these funds generally include popular S&P 500 funds, total market funds, and large-cap stock funds.
This category has performed very well historically. Over an extended period, the S&P 500 averages around 10% annual returns. There are up and down years, and past performance is no guarantee of future performance. But if you buy and hold, or “VTI and chill,” as some investors say, you should expect strong performance over a few decades.
International Stock Fund
International stock funds focus on companies outside the US, including stocks traded in markets like the London Stock Exchange, Tokyo Stock Exchange, and many others. They also hold many different stocks. For example, VT, the Vanguard Total World Stock Index Fund ETF, has nearly 10,000 global investments.
Global stocks are sometimes considered a little riskier than US stocks, and they haven't performed as well as domestic stocks in recent years. But holding both provides a little more diversification and allows outsized performance if the US economy lags.
Bond Fund
Bonds provide a fixed income, often leading to more predictable returns. While bond prices typically rise and fall with an inverse relationship to interest rates, knowing that you’re lending money to large, stable companies at a fixed rate can lead to a more stable, lower-risk pillar of your portfolio. But they’re certainly not risk-free.
Examples include BND, Vanguard’s Total Bond Market ETF, which has more than 11,000 holdings and a palatable 0.03% expense ratio. IUSB, the iShares Core Total USD Bond Market ETF, holds more than 16,000 securities and charges 0.06% annually.
More information here:
The 15 Questions You Need to Answer to Build Your Investment Portfolio
How to Build a 3-Fund Portfolio
You can invest in a three-fund portfolio in less than 10 minutes, though you may want to take more time to research the best asset allocation and pick your favorite funds beyond the examples we discuss here.
Step 1: Choose Your Asset Allocation
Start by choosing your ideal asset allocation. An example could be something like this:
- US Stocks: 50%
- International Stocks: 20%
- Bonds: 30%
There’s no exact right or wrong answer here. As a typical guideline, younger investors with more time before retirement are more heavily weighted in stocks. Those nearing retirement with less time to recover from a market downturn shift more heavily into bonds. Stocks are riskier but come with an opportunity for higher returns. Bonds are considered a little less risky and typically provide lower returns.
Step 2: Pick Your Funds
Next, pick your favorite funds within those categories. Major decisions to help you hone in on the right funds include:
- Mutual fund vs. ETF: ETFs trade instantly like stocks, while mutual funds trade at market close. ETFs often have lower expense ratios. You have a few more considerations for taxable investment accounts, but most of the time, an ETF is best for modern investors.
- Expense ratio: Expense ratios are how investment fund managers get paid and are expressed as a percentage of your portfolio value per year. The best broad market index funds charge less than 0.10% per year. Paying less is better, of course.
- Historic performance: We’ve already discussed that past performance is no guarantee of future performance, but some funds tend to perform better than others within the same category. When comparing multiple, similar funds, past performance could be a tiebreaker.
- Availability and commissions: Most ETFs trade with no commissions at major brokerages. Most have a no-fee mutual fund list, which usually includes their own funds and potentially a list of additional funds from preferred investment managers. You may find that a specific mutual fund you want requires high fees with your current brokerage, which could lead you to pick another fund or open an account elsewhere.
Step 3: Monitor and Rebalance
Part of the beauty of a three-fund portfolio is that you can make your investment decisions and then you don’t have to check in frequently. But you should monitor your performance periodically. Whether that’s monthly or quarterly, for example, it’s a good idea to check in and ensure you don’t encounter any big surprises.
If your portfolio drifts away from your target allocation over time, you may want to sell some of one fund and use the proceeds to buy more of another. However, some investors don’t like rebalancing, as it involves selling your best-performing investments to acquire more of your worst-performing holdings.
More information here:
How to Build an Investment Portfolio for Long-Term Success
Is a 3-Fund Portfolio Right for You?
I hold about a dozen funds in my portfolio, but I reviewed them while writing this article and could see how they may consolidate into just three funds. While I don’t think a three-fund portfolio is best for me, many investors, particularly those without extensive investment knowledge, may find fewer funds best.
If you’re a busy medical professional and don’t have time to tinker with single stocks or large fund portfolios, a three-fund portfolio could be the perfect solution for your unique investment needs.
3-Fund Portfolio FAQs
What is the best three-fund portfolio for beginners?
The best three-fund portfolio for beginners is likely a combination of a domestic stock ETF, a global stock ETF, and a total bond market ETF. Consider your brokerage’s family of funds for an easy way to start.
Is a three-fund portfolio enough for retirement savings?
There’s no rule that retirement savings have to be complex. A simple three-fund portfolio could be enough for retirement savings.
How does a three-fund portfolio compare to other investment strategies?
A three-fund portfolio gives you less fine-tuned control over your investments but makes portfolio management simpler.
Can I customize a three-fund portfolio?
You can add or remove funds from your portfolio at any time. With a three-fund portfolio, you can choose your target funds and the percentage of your portfolio invested in each of the three funds, giving you some flexibility and customization options.
The White Coat Investor is filled with posts like this, whether it’s increasing your financial literacy, showing you the best strategies on your path to financial success, or discussing the topic of mental wellness. To discover just how much The White Coat Investor can help you in your financial journey, start here to read some of our most popular posts and to see everything else WCI has to offer. And make sure to sign up for our newsletters to keep up with our newest content.
