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Own It All

Greg Spears

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:

  • Total U.S. stock market index fund
  • Total international stock market index fund
  • Total bond market index fund

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.

  • Vanguard Total Stock Market Index Fund (symbol: VTSAX) had portfolio holdings that ran to 4,066 stocks as of Sept. 30, everything from Apple to Rocky Mountain Chocolate Factory. It owns a representative sampling of large-, mid- and small-cap stocks, plus growth and value shares. Nothing’s worked this year. The fund was down 18.8% year-to-date as of Oct. 31.
  • Vanguard Total Bond Market Index Fund (VBTLX) owned 10,174 bonds as of Sept. 30. It’s roughly two-thirds U.S. Treasurys or guaranteed government agencies and one-third corporates. It has an average duration of nearly seven years, a measure of interest-rate sensitivity. If interest rates rise by one percentage point, you can expect the fund to lose 7%. That helps explain its 15.8% loss this year, as the Federal Reserve has jacked up rates like it was changing a tire on Jerome Powell’s car.
  • Vanguard Total International Stock Index Fund (VTIAX) adds another 7,991 stocks of companies from more than 40 countries, including both developed and developing nations. The largest allocation is to Japanese shares at 15.5%, then the United Kingdom at 9.9% and China in third position at 8.7%. Again, nothing’s worked. The fund’s year-to-date loss was 24.3% as of Oct. 31. Ouch.

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.

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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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Cammer Michael
Cammer Michael
2 months ago

I mostly stick to this strategy, but I’ve also had a side thing going of energy royalty trusts. Their price has been very volatile, but the tax free income stream has beat cash and if you don’t need to sell, then you can ride out the down days, or down years. And during up periods, such as now, the royalties more than cover our energy costs and then some.

William Perry
William Perry
2 months ago

Thanks for the article Greg.

Do you have thoughts regarding factors in choosing between the world equity fund VTWAX versus a combination of VTSAX and VTIAX? My current long term thinking is to own VTWAX in a Roth for investments I hope my wife and I will never need to sell and will leave to our kids.

Jonathan Clements
Admin
Jonathan Clements
2 months ago
Reply to  William Perry

That’s the strategy I’m using with my “bequest” money:

https://humbledollar.com/2022/02/paying-it-forward/

Kevin Knox
Kevin Knox
2 months ago

As a Boglehead for decades I appreciate the appeal of the Three Fund portfolio, but also feel obliged to point out that there are many sharper tools in the shed. As it happens, there’s a new thread on the Bogleheads forums at the moment where experienced Vanguard investors are poking holes in it – starting, for example, by pointing out that investors have been and continue to be punished for including international equities for decades, or that Intermediate-term Treasuries are a better choice (in terms of credit quality, duration and response to market panics) than Total Bond. Last not least, Total Stock Market owns a lot of stocks but because it is market cap constructed (and unlike the S & P 500 doesn’t exclude companies that have yet to turn a profit) its returns are in fact entirely driven by the performance of the 5 so-called FAANG stocks (Facebook, Apple, Amazon & Google), while small-cap and value stocks are hardly represented.

Meanwhile both the Three Fund and Vanguard’s own Target Date and LifeStrategy funds based on it have miserably underperformed both Wellesley and the simple all-U.S. Balanced Index Fund for decades – and not by a little.

It’s also illuminating to compare the risk-adjusted returns, drawdowns and safe withdrawal rates of the Three Fund with other popular lazy portfolios on this site, starting perhaps with the Merriman Ultimate or Golden Butterfly, which are among many portfolios that do a much better job in all market conditions than the simple but rather crude Three Fund.

https://portfoliocharts.com/portfolios/

Brent Wilson
Brent Wilson
2 months ago
Reply to  Kevin Knox

Putting aside whether there are “better” portfolios, many are drawn to the simplicity of the three-fund portfolio because they know they can stick with it.

It’s really easy to find merit in many of the portfolios on that site. Finding one you can stick with over time is critical. As Warren Buffet says, “For investors as a whole, returns decrease as motion increases.”

Derek R. Austin
Derek R. Austin
2 months ago
Reply to  Brent Wilson

Arguably, the 2 funds for life strategy from Merriman addresses Kevin’s “holes” while being even simpler than the 3 funds strategy.

Kevin Knox
Kevin Knox
2 months ago
Reply to  Brent Wilson

Couldn’t agree more Brent, which is why I recommended that folks check out portfolios that offer more consistent returns and shallower, shorter drawdowns than the 3 Fund, since as William Bernstein and many others have pointed out such volatility is the most frequent cause of behavioral error/inability to “stay the course” among even seasoned investors.

To be clear, I think the 3 Fund is still a good portfolio but don’t see any reason why it should be a default or blanket recommendation. Heck I’d even choose the Jonathan Clements 3 Fund (~60-80% VT, the rest in VGSH and VTIP) over the Vanguard version :-).

John Redfield
John Redfield
2 months ago

Good article. A similar approach is promoted by Scott Burns with his Couch Potato Portfolio, which he introduced in September 1991. I’m surprised that he is not mentioned more on the HD. I once jokingly emailed Jonathon and asked if he and Scott were the same person. He emailed me back (with appropriate humor) and assured me they were not. Another of Jonathon’s strengths is that he takes the time to answer emails.
http://www.scottburns.com

mytimetotravel
mytimetotravel
2 months ago

If you are going to point out the losses in those funds this year, you should also explain where one could do better. (I am a long-time Vanguard investor and my only move this year has been to tax-loss harvest one fund.)

Jonathan Clements
Admin
Jonathan Clements
2 months ago
Reply to  mytimetotravel

Greg makes clear he’s a fan of the three-fund portfolio. But he could hardly write a piece on the topic without noting the shellacking that investors have suffered this year.

mytimetotravel
mytimetotravel
2 months ago

True, but other approaches may well have done worse.

Martymac
Martymac
2 months ago

Curious what kind of yield this kicks off? As a new retiree, I am shooting for 2/3 of my withdrawal to come from dividend or interest income.

Greg Spears
Greg Spears
2 months ago
Reply to  Martymac

The dividend yields of the three funds are:
Total U.S. Stock Market Index 1.66%
Total U.S. Bond Market Index 4.38%
Total International Stock Market Index 3.52%

James Mahaney
James Mahaney
2 months ago

Nice article Greg. Fully a believer in the simple approach you outline. I’ll just add that stable value funds are not down this year and are a great investment for many new retirees who keep some assets in their employer’s 401(k). Stable value investments are also a good choice to “bridge” to a higher delayed Social Security benefit.

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