The Money Muse

A three-fund portfolio is a simple and effective investment strategy that can help you build long-term wealth with minimal effort and cost. As the name suggests, it involves three types of index funds: one for domestic stocks, one for international stocks, and one for bonds. This strategy is often recommended for its simplicity, low fees, and ability to provide diversification across different asset classes.

Why choose a three-fund portfolio?

The three-fund portfolio is a popular choice among investors because it offers a diversified investment approach that’s both easy to manage and cost-efficient. Diversification helps reduce risk by spreading your investments across different types of assets, which means you’re less likely to be negatively impacted by the poor performance of a single asset class.

This strategy also allows investors to maintain a balanced portfolio with exposure to both domestic and international markets, as well as a safer bond allocation to reduce volatility. It’s particularly attractive to long-term investors who prefer a set-it-and-forget-it approach to their portfolios.

The simplicity of the three-fund portfolio lies in its ability to match most investors’ needs without requiring constant monitoring or complex decisions. By allocating a percentage of your portfolio to each of the three asset classes, you can create a balanced investment approach suited to your risk tolerance and goals.

Components of a three-fund portfolio:

1. Domestic stocks (U.S. stocks). The first fund in a three-fund portfolio represents your exposure to domestic equities (U.S. stocks). U.S. stocks tend to offer a higher potential return but come with more risk, especially during market downturns. Allocating to U.S. stocks gives you access to the performance of the American economy.
   Popular U.S. stock index funds:
   • Vanguard Total Stock Market Index Fund (VTSAX). This fund tracks the performance of the entire U.S. stock market, including small, mid, and large-cap stocks. VTSAX offers broad diversification within the U.S. market at a low cost, making it a popular choice for many investors.
   • Fidelity 500 Index Fund (FXAIX). This fund tracks the S&P 500, which includes the 500 largest companies in the U.S. and is a commonly used proxy for the overall U.S. stock market.
2. International stocks (global exposure). The second fund in the portfolio provides exposure to international markets, helping diversify your holdings beyond the U.S. economy. This is particularly important since global markets often behave differently from U.S. markets, and investing internationally can enhance the growth potential of your portfolio.
   Popular international stock index funds:
   • Vanguard Total International Stock Index Fund (VTIAX). This fund offers exposure to both developed and emerging markets outside the U.S. and Canada. It’s a great option for broad international diversification.
   • Fidelity International Index Fund (FSPSX). This fund tracks the performance of the MSCI EAFE Index, which includes large and mid-sized companies in Europe, Australasia, and the Far East.
3. Bonds (fixed income). The third fund in a three-fund portfolio consists of bonds, which provide a stable source of income and help reduce the overall risk of the portfolio. Bond funds tend to be less volatile than stocks, which can help balance the fluctuations of the equity portion of your portfolio. A bond fund can also act as a hedge during stock market downturns.
   Popular bond index funds:
   • Vanguard Total Bond Market Index Fund (VBTLX). This fund tracks the performance of the U.S. investment-grade bond market, including government, corporate, and mortgage-backed securities. It’s a popular choice for a well-diversified bond allocation.
   • Fidelity U.S. Bond Index Fund (FXNAX). This fund also provides broad exposure to the U.S. bond market, investing in U.S. Treasuries, investment-grade corporate bonds, and mortgage-backed securities.

How to build a three-fund portfolio:

1. Determine your asset allocation. The next step is deciding how much to allocate to each of the three funds. This depends on your risk tolerance, investment goals, and time horizon. For example:
   • A more aggressive investor might allocate 80% to U.S. stocks, 15% to international stocks, and 5% to bonds.
   • A more conservative investor might opt for 40% in U.S. stocks, 20% in international stocks, and 40% in bonds.
2. Automate your investments. One of the benefits of a three-fund portfolio is that once you’ve decided on your allocations, you can set up automatic contributions to each fund. This allows you to invest consistently without having to make frequent decisions or monitor the market closely.
3. Rebalance periodically. Over time, the value of your investments will fluctuate, causing your asset allocation to shift. It’s important to rebalance your portfolio periodically – usually once or twice a year – to ensure it stays aligned with your desired allocation. Rebalancing is a simple process of selling some of the funds that have grown larger than expected and buying more of the underperforming funds.

Why a three-fund portfolio is effective.

The three-fund portfolio is a solid choice for long-term investors who want a simple yet diversified approach. By investing in U.S. stocks, international stocks, and bonds, you’re covering most of the important asset classes and ensuring that your portfolio has the right mix of growth and stability.

With low fees, automatic rebalancing, and no need for constant oversight, the three-fund portfolio makes investing accessible to everyone, regardless of experience. It’s a strategy that can grow with you as you reach new financial milestones, offering both security and the potential for long-term wealth accumulation.

Final thoughts.

Building a successful investment strategy doesn’t have to be complicated. A three-fund portfolio is an easy, low-maintenance way to ensure you’re invested in a diversified mix of stocks and bonds, and it’s an excellent option for people who prefer a hands-off approach to investing. By choosing a combination of index funds, you can achieve broad market exposure and benefit from long-term growth with minimal cost and complexity.