Choosing an investment strategy is one of the most fundamental aspects of investing. Being an active or passive investor, deciding which investment types to use, and knowing your asset allocation are all elements of an investment strategy.
Each of these components requires thought and care to implement, and there are countless ways to do it. A three-fund portfolio is a very simple way to execute many of the elements of an investment plan all in one strategy.
What Is a 3-Fund Portfolio?
This is because, with fewer funds, you have less to track and fewer transactions to make when adding money to your portfolio or rebalancing it than you would with a portfolio that contains many more investments.
While the particular three funds can vary, this strategy typically uses domestic stock, international stock, and bond index funds. Index funds are a popular choice for this strategy because they have lower expenses than active funds and provide diversification across an entire asset class.
Because of their simplicity, low-fees, and diversification, three-fund portfolios are very popular among the Boglehead community of DIY investors, so named for their adherence to investing principles championed by Vanguard founder John Bogle.
A three-fund portfolio is a complete portfolio that consists of just three mutual funds or exchange-traded funds (ETFs). By using just three funds, you can simplify not only the implementation but the ongoing management of your investments.
Measuring Annual Performance of a 3-Fund Portfolio
As with any investment strategy, you need to be able to track the performance of a three-fund portfolio.
To track and measure the historic performance of a three-fund portfolio you need to first choose the three funds that you want to include in your portfolio and look up the historical return of each.
Next, you’ll need to decide on the weighting of each fund within the portfolio. To illustrate this, let’s say you create a three-fund portfolio with these three ETFs:
- VTI: Vanguard Total Stock Market ETF (U.S. total stock market fund)
- VEU: Vanguard FTSE All-World ex-US ETF (international stocks)
- BND: Vanguard Total Bond Market ETF (bond fund)
For simplicity, let's assume you allocate the portfolio as evenly as possible across the three funds: 33% in each of the stock funds and 34% in the bond fund. We would calculate the total market return for this portfolio for 2020 as follows by first looking at the weighted average of each fund, which is annual return multiplied by allocation:
Your total 2020 market return would be the sum of the weighted average of each fund: 13.21%. You could then use this to determine if the annual return is what you’re looking for with your investment. While past performance never guarantees future returns, it may offer some insight into how the fund could perform over time.
Measuring a 3-Fund Portfolio’s Performance Over 5 and 10 Years
Going back five or 10 years instead of just one year can give you a better sense of how a three-fund portfolio has performed.
Varying your allocations can strengthen your research, too. In addition to the moderate (33%, 33%, 34%) allocation in the previous example, you could choose a conservative approach where you allocate 10% to each stock ETF and 80% to the bond ETF. Or, you could try a more aggressive approach with 40% allocated to each stock ETF and the remaining 20% to the bond ETF.
Let’s take a look at how each of these three-fund portfolios have performed over the last five and 10 years. Each year in the table below uses the weighted average.
(10%, 10%, 80%)
(33%, 33%, 34%)
(40%, 40%, 20%)
The table below shows the average rate of return for each of the portfolios over the past five and 10 years. As you can see, even though the portfolios were constructed from the exact same ETFs, the specific asset allocation choice made a significant difference in the return of each portfolio.
If you invest in your own three-fund portfolio, then your account statement should show your performance, too.
Building Your Own 3-Fund Portfolio
To build your own three-fund portfolio, start by figuring out what your objectives, risk tolerance, and time horizon are. This is the first step of any investment strategy to determine your asset allocation and make sure that your investment plan is right for you.
Once you decide on an asset allocation strategy, you need to pick the individual mutual funds or ETFs you want to build your portfolio with. Remember, a three-fund portfolio is typically built with low-cost index funds because of their low fees and broad diversification. Implementation is a matter of buying your funds of choice in your chosen asset allocation proportions.
To maintain your asset allocation, you’ll need to rebalance your portfolio periodically, either at regular intervals or when it strays too far from the designated allocation.
Should You Have a 3-Fund Portfolio?
No investment strategy is universally appropriate for everyone or applicable to every situation. A simple three-fund portfolio may be right for you if you value simplicity, low-cost, and like to handle things yourself, but you could also try a four-fund portfolio or even one with five funds—it’s all up to you. Fine-tune your allocation strategy to match your risk tolerance, too. Whether you’re an aggressive or conservative investor, you’ll eventually find your sweet spot.