What Is a Three-Fund Portfolio?

A three-fund portfolio offers investors a streamlined approach to building a diversified investment portfolio. This strategy is recognized for its simplicity and efficiency, providing broad market exposure while minimizing both costs and complexity.

The Foundation of a Three-Fund Portfolio

A three-fund portfolio utilizes three low-cost, broadly diversified index funds or exchange-traded funds (ETFs) to encompass major global asset classes. This investment strategy simplifies decision-making by reducing the number of individual holdings an investor needs to manage. It aims to capture the returns of the entire stock and bond markets, spanning both domestic and international economies. By tracking entire market segments, these funds provide exposure to a wide array of assets, which helps in spreading investment risk. The emphasis on index funds and ETFs ensures that the portfolio benefits from lower expense ratios compared to actively managed funds.

Deconstructing the Three Funds

A typical three-fund portfolio includes a Total U.S. Stock Market Index Fund, a Total International Stock Market Index Fund, and a Total Bond Market Index Fund. Each fund serves a distinct purpose in achieving broad market exposure and diversification.

The Total U.S. Stock Market Index Fund provides exposure to the entire spectrum of publicly traded companies within the United States, including large, mid, and small-capitalization stocks. This fund captures the growth potential of the domestic equity market. It tracks comprehensive indexes that often include thousands of U.S. companies.

A Total International Stock Market Index Fund extends diversification by investing in publicly traded companies outside the United States. This component provides exposure to global economies and helps to mitigate single-country risk. Such funds typically include stocks from developed and emerging markets worldwide, often tracking broad international indexes.

The Total Bond Market Index Fund primarily invests in a broad range of investment-grade bonds, commonly within the U.S. bond market. This fund provides stability, generates income, and potentially reduces overall portfolio volatility. It holds government, corporate, and mortgage-backed securities across various maturities.

Building Your Portfolio

Constructing a three-fund portfolio involves selecting specific low-cost index funds or ETFs that correspond to the three asset classes. Investors can choose products from major providers known for their competitive expense ratios, which for index funds can be as low as 0.03% to 0.15% annually. These funds are available through various investment accounts, including individual brokerage accounts, Individual Retirement Arrangements (IRAs), or employer-sponsored 401(k) plans.

A primary consideration when building the portfolio is asset allocation, which determines the percentage split among stocks and bonds, and between U.S. and international stocks. This allocation is a personal decision, influenced by factors such as an investor’s risk tolerance and investment horizon. For instance, a younger investor with a longer time horizon might opt for a higher stock allocation, such as 80% stocks and 20% bonds, while someone closer to retirement might prefer a more conservative 60% stocks and 40% bonds.

Determining the appropriate asset allocation involves assessing one’s comfort with market fluctuations and the timeframe for needing the invested capital. A longer time horizon allows for greater exposure to stocks due to more time to recover from potential downturns. Conversely, a shorter time horizon necessitates a larger allocation to bonds for greater stability and capital preservation.

Ongoing Portfolio Management

Managing a three-fund portfolio is straightforward and requires minimal active intervention once established. A primary aspect of ongoing management is rebalancing, which involves adjusting the portfolio back to its target asset allocation. This process helps manage risk and maintain the desired exposure to each asset class as market values fluctuate.

Rebalancing can be done periodically, such as annually or semi-annually, or when an asset class deviates by a certain percentage from its target allocation, for example, 5% or 10%. Rebalancing within tax-advantaged accounts like IRAs or 401(k)s does not trigger taxable events. However, rebalancing in taxable brokerage accounts by selling appreciated assets can result in capital gains taxes, subject to short-term or long-term rates depending on the holding period.