How to Build a Classic 3-Fund Portfolio With ETFs
Successful Investing Doesn’t Have to Be Complicated
There is plenty of investing advice available, but the truth is that the average investor consistently underperforms the market. According to the 2020 DALBAR Quantitative Analysis of Investor Behavior study, mutual fund investors earned 30% less than the S&P 500 over the period 2000-2019. The poor results can be attributed to investor emotions and behaviors that lead to buying high and selling low.
But it doesn't have to be that way.
The three-fund ETF portfolio is a simple, low cost investment strategy that has consistently outperformed average investors. Whether you're just getting started with a little money or you're a seasoned investor, the three-fund strategy has something for everyone.
What Are ETFs?
ETFs (exchange-traded funds) are a cost-effective way to invest in many different stocks, bonds, and other assets. They're a basket of securities that are traded on exchanges like the NASDAQ and the NYSE (New York Stock exchange) and have the following characteristics:
- They are liquid, just like individual stocks.
- They typically have very low expenses
- ETFs are transparent, publishing their holdings daily
ETFs are available that track very broad financial indexes, like the Wilshire 5000 and Barclays/Bloomberg Aggregate U.S. bond index. Index ETFs hold each of the securities that are included in the index tracked.
The 3-Fund ETF Portfolio
The three-fund portfolio strategy allocates stock and bond investments between three types of exchange-traded funds: a total U.S. stock market index fund, a total U.S. bond market index fund, and a world stock market fund, excluding the U.S.
The three-fund ETF portfolio provides investors with ownership of more than 12,000 individual worldwide securities. The specific funds chosen and percentage allocated to each ETF are up to the investor based on their preferences, time horizon, and risk tolerance.
How to Allocate Your 3-Fund ETF Portfolio
Asset allocation is how a portfolio is divided up across stocks, bonds, cash, and other types of investments to manage risk. Your allocation should be compatible with your financial goals, time horizon, and personality.
Aggressive investors are willing to risk losing more of their portfolio to achieve higher returns. Conservative investors are concerned with preserving their portfolio, and are willing to accept lower returns. For example, an aggressive investor may allocate more to U.S. and international stocks, while a conservative investor may have a larger allocation to bonds. But it’s not quite that simple. An aggressive investor nearing retirement may find it more prudent to allocate a larger percentage to bonds.
To determine how much you should allocate to stocks and bonds, start with an online calculator. Vanguard, Fidelity, Schwab, and other financial services companies have online tools to help you determine an allocation between stocks and bonds that is comfortable for you and lines up with your financial goals.
The sample allocations below are based on the 10-year performance of Vanguard ETFs.
|Sample 3-Fund ETF Allocations|
|Target||Total Stock ETF||World ex U.S. ETF||Total U.S. Bond ETF||10-Year Return|
Rebalancing a 3-Fund ETF Portfolio
Market performance will increase and decrease the relative percentages of your three funds as part of your overall portfolio. In other words, the allocations will change over time because of ETF returns.
Rebalancing means moving money between the funds to maintain your desired allocation, which is the one you started with. For example, suppose you start with a $10,000 portfolio and invest 50% in a stock fund and 50% in a bond fund.
After three years, the portfolio grows to $12,000, and the allocation becomes 55% stock fund and 45% bond fund. All that’s needed to return to the original 50/50 allocation is to sell $650 of the stock fund and buy $650 of the bond fund.
Your 3-Fund ETF Portfolio Accounts
Asset location is how your portfolio is allocated between different types of accounts. If you are early in your career, your employer’s retirement plan is likely where most of your investment portfolio is. If you are further along, you may also have money in taxable accounts like a brokerage account, or in a tax-deferred account like an annuity. In that case, you can decide where the investments go to yield the best results.
Generally, a taxable bond ETF will benefit more from a tax-deferred or tax-exempt account than a stock market (equity) ETF. That's because taxable bond funds pay interest that is taxed at ordinary income rates rather than the lower capital gains rates for ETF distributions and qualified dividends.
The Benefits of a 3-Fund ETF Portfolio
- Simple but effective: There are very few "moving parts." Investors are highly diversified because each of the three ETFs hold thousands of different domestic and international securities. A highly diversified portfolio reduces risk without sacrificing too much return.
- Inexpensive: Average expenses for a three-fund ETF portfolio are about one-third of the average cost of a mutual fund.
- Easy to manage contributions and withdrawals: The more funds you have in your portfolio, the harder it is to split up contributions or decide which fund to withdraw money from.
- Easy to rebalance: At least once a year, check the portfolio to see if the allocation percentages between stocks and bonds is still consistent with your plan. If not, then you can rebalance.
Best of all? Research shows that a three-fund ETF portfolio consistently outperforms most investors, even professionals.
How to Build a 3-Fund ETF Portfolio
Decide on your asset allocations: Every investment plan begins here. Decide how much of your portfolio you want to put in each ETF, according to your risk tolerance. You can use online tools available from providers like Vanguard and Fidelity.
Decide on your asset locations: If you are in a position to invest money outside of your employer’s retirement plan, decide whether you will use a taxable, tax-deferred, or tax-exempt account.
Open an account: ETFs are purchased through retirement plans, like your employer's 401(k), or brokerage accounts. If you don't already have one, you will need to open one.
Select your ETFs: The three ETFs—Total U.S. stock market, Total U.S. Bond market, and Total World Stock market—are available from many providers. Blackrock, Vanguard, Fidelity, and T. Rowe Price, are just a few
Maintain your plan: Review your portfolio at least twice a year to be sure your allocation percentages haven't changed due to market performance. Rebalance as necessary.
Consult a professional: You may want to consider consulting a fee-only professional to help you with your decisions, and rebalancing your portfolio.
The Balance does not provide tax, investment, or financial services and advice. The information is presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk, including the possible loss of principal.