ONLY CASH IS SHOWING a positive return this year, while most parts of the stock and bond market have suffered double-digit losses. And with inflation spiking, even cash investments have been a losing proposition in 2022. With nowhere to hide, perhaps it’s time to renounce active management and consider the three-fund portfolio.
Long championed on the Bogleheads forum, the three-fund portfolio is an indexing approach that drives down costs, feasts on diversification and ends investment selection errors by sticking with just three funds:
It’s the everything bagel of investing. If a security is listed in a major index, one of these funds will likely own it—with the notable exception of foreign bonds. The three funds combined own more than 22,000 stocks and bonds, according to Sept. 30 figures from Vanguard Group’s website. By owning it all, you could expect to earn the global stock and U.S. bond markets’ total returns, less expenses—and those, it turns out, are minuscule.
The three-fund portfolio is essentially a bet on the long-term prospects of capitalism and the world economy. Which will be back, I’m sure… if we’re patient. If you accept that we invest to earn a generous long-term return—short-run is another matter entirely—then the three funds offer an elegant plan. It only works, however, if investors remain steadfast when the markets melt down. With that caveat, let’s use Vanguard’s offerings to look at the portfolio’s three components.
By the way, you don’t need Vanguard mutual funds to assemble this portfolio. Fidelity Investments or Charles Schwab’s mutual funds could do the trick as well. You could also invest in exchange-traded funds from iShares, Vanguard and elsewhere, which might cost less. Almost no matter which major fund company you choose, the three funds’ expenses are as light as a feather. That’s because these funds are forever owners, selling out entirely only if a security is dropped from an index, plus there’s no overpaid stock-picker at each fund’s helm.
The turnover rate of Vanguard Total Stock Market was 4% in 2021, versus 63% in 2019 for the average actively managed U.S. stock fund. Far less is spent on brokerage commissions and bid-ask spreads, the often-overlooked costs of fund ownership not counted in the expense ratio. Fewer trades can also mean lower realized capital gains, a help to investors with taxable accounts.
Speaking of expenses, Vanguard Total Stock Market Index mutual fund has an expense ratio of 0.04%. The average actively managed fund charged 0.68% in 2021, according to the Investment Company Institute, or 17 times as much. Vanguard Total Bond costs 0.05%, compared to 0.6% for the average bond fund. The lower the expenses, the more return that’s left for the investor. In this case, less truly is more.
With all of this to recommend it, what could be wrong with the three index-fund portfolio? Mainly this—capturing the return of the stock and bond markets in 2022 has been a terrible, awful no good thing. With energy shocks, inflation and rising interest rates, there could be further to fall.
Then there’s a quibble over what might be missing. Index purists, for instance, might want to add international bonds. They might create a four-fund portfolio by adding Vanguard Total International Bond Index Fund (VTABX). A rising U.S. dollar—as happened this year—can scupper even the best international bond fund’s results unless it’s hedged against currency risk. Vanguard’s international bond fund does that.
This still leaves the big questions of what proportion of stocks and bonds to own, and how much to allocate to foreign shares. There’s no right answer, but investors should be careful to avoid naïve diversification. That would be the tendency to give stocks a two-thirds weighting simply because the three-fund portfolio consists of two stock funds and one bond fund. People do this all the time within 401(k) plans.
If asset allocation decisions give you agita, you can always default to the big kahuna—an all-in-one target-date fund. They own everything, too, but professionals manage the asset allocation to gradually lower risk as the target date approaches. They’re now used by a majority of Vanguard 401(k) investors, who only have to know the year they expect to retire to choose a fund.
Intellectually, indexing makes all the sense in the world for long-term investing, say longer than five years. But emotionally, this is a challenging time to be an investor. Tempted to shift to the three-fund portfolio? You might find it emotionally easier if you tiptoe into your new portfolio. Want to read more about the three-fund mix? Check out The Bogleheads’ Guide to the Three-Fund Portfolio, a 2018 book by Taylor Larimore.
Greg Spears is HumbleDollar’s deputy editor. Earlier in his career, he worked as a reporter for the Knight Ridder Washington Bureau and Kiplinger’s Personal Finance magazine. After leaving journalism, Greg spent 23 years as a senior editor at Vanguard Group on the 401(k) side, where he implored people to save more for retirement. He currently teaches behavioral economics at St. Joseph’s University in Philadelphia as an adjunct professor. The subject helps shed light on why so many Americans save less than they might. Greg is also a Certified Financial Planner certificate holder. Check out his earlier articles.
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