The three-fund portfolio is a simple, low-cost investment strategy that has become popular with many investors. Whether you're just getting started or are a seasoned investor, the three-fund strategy can work for you.
There are many ways to compose a three-fund portfolio. Using exchange-traded funds (ETFs) is a solid way to start, since they tend to be diverse and stable. Find out how to make and maintain a three-fund ETF portfolio.
- A three-fund ETF portfolio often includes a total U.S. stock market index fund, a total bond market index fund, and a world stock market fund.
- How you allocate your portfolio depends on your risk tolerance, goals, and time horizon.
- Decide where you want your assets to be located based on the type of asset and its tax treatment.
What Are 3 Fund ETF Portfolios?
The three-fund ETF portfolio strategy follows the same format as the more broad three-fund portfolio. It 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 (without U.S. investments).
ETFs are a cost-effective way to invest in many different stocks, bonds, and other assets. They are called as such, because when you invest in an ETF you are putting your money into a basket of securities that are traded on exchanges like the NASDAQ and the New York Stock Exchange. All ETFs have the following traits:
- They are liquid, just like stocks.
- They typically have very low expenses
- They are transparent, meaning their stats on pricing, and other figures are out there for all to see, and holdings are published daily.
Depending on the ETFs you choose, a three-fund ETF portfolio could provide you with ownership of thousands of individual worldwide securities. It is up to you how you will select the specific funds, and how they are allocated within your portfolio. Such choices depend on your own investing preferences, time horizon and risk tolerance.
You can find ETFs that track broad financial indexes, like the Wilshire 5000 and Barclays/Bloomberg Aggregate U.S. bond index. Index ETFs are called such because they hold each of the securities that are included in the index being tracked.
How to Build a 3-Fund ETF Portfolio
You can begin your investment plan by thinking about asset allocation and where the assets will be located. Decide how much of your portfolio you want to put in each ETF, based on your risk tolerance.
What is Asset Allocation?
Asset allocation is how a portfolio is divided up across stocks, bonds, cash, and other types of investments to best manage your level of risk. Some types of assets come with greater risk than others, so you can control how much risk your fund will take on by putting more weight on particular assets. You should also think about the time span of your fund. Some assets are better suited for steady long-term growth, while others may be more liquid for short-term needs. The way you allocate your funds should be compatible with your financial goals, time horizon, and risk tolerance. The table below is a sample of what a three-fund ETF portfolio and returns might look like.
|Sample 3-Fund ETF Allocations|
|Target||Total Stock ETF||Total World ETF (No U.S.)||Total U.S. Bond ETF||10-Year Return|
|Conservative (Low Risk)||30%||10%||60%||6.30|
|Moderate (Moderate Risk)||45%||15%||40%||7.70|
|Aggressive (High Risk)||50%||20%||30%||8.18|
What is Asset Location?
You also need to decide where you want your assets located. Asset location refers to placing your investments in a type of account that can do the most good for the specific kind of investment.
For instance, a tax-deferred account is good for bonds because they are taxed at the higher income tax rates rather than the capital gains tax rate. Stocks are taxed at the lower capital gains tax rate, so they would be better in a taxable account. These choices will also depend on your tax bracket.
If you are early in your career, chances are most of your savings are in your employer’s retirement plan. (There are always outliers of course). If you are further along in your career, you may also have money in taxable accounts like a brokerage account or a tax-deferred account. In that case, you can decide where to invest your money to yield the best results.
Rebalancing Your Portfolio
Rebalancing means moving money between the funds to maintain your desired asset allocation. This is a useful tactic, since your allocation is likely to change over time as you build capital and move through your career.
For instance, suppose you start with a $10,000 portfolio and invest 50% in a stock fund and 50% in a bond fund. After the second year, the portfolio grows to $12,000, and the allocation becomes 55% stock and 45% bond. To return to the original 50/50 allocation, you need only sell $600 of the stock fund and use it to buy $600 worth of bonds.
You should look at your portfolio often as you move through your career and gain new capital, but also as you reach certain lifetime milestones. Your goals and tolerance for risk may change, for instance, if you get married, start a family, or buy a home.
The Benefits of a 3-Fund ETF Portfolio
Three-fund ETFs portfolios have many features that make them attractive to investors seeking returns and stable growth:
- They are less costly than other portfolio builds
- They lessen foreign investment risks
- Contributions and withdrawals are simple
- Fewer funds make it easier to rebalance
Since each of the three ETFs holds thousands of different domestic and international securities, your fund will be very diverse. A highly diversified portfolio reduces risk without sacrificing too much return. This is especially true when adding international and foreign investments.
The costs that come with ETFs are close to one-third of the average cost of a mutual fund. If you were to build a three-fund portfolio from mutual funds, you'd likely pay three times as much in fees as you would for an ETF-based portfolio.
Less asset movement within the portfolio combined with much lower fees means you keep more of your capital invested. This will increase the value of your portfolio that much more.