When you read about investing you hear a lot of jargon, most of which we hopefully explained in the last post. You hear a lot of about asset allocation and risk tolerance and financial planning, but you’re rarely told what is a wise investment. The closest you get is someone telling you what to invest in, and when that happens you’re probably better off not following their advice because it’s some speculative stock or startup company. So what is a wise investment? What investments should you actually buy? Source: xkcd.com
One of the simplest and most efficient ways to invest is what’s called the Three Fund Portfolio, so named because it only invests in three different funds. It’s also called the Lazy Portfolio. A Three Fund Portfolio consists of an American total stock market index fund (which we recommended in our post What is Financial Independence), an international total stock market index fund and a total bond market index fund.
With just these three funds an investor can invest in over 10,000 different assets and securities all over the world!
The idea of this simple set of index funds is that you’ll get exposure to the American stock market, the international market, and the bond market. The American stock market is probably the greatest wealth-creation tool ever created. Most other countries have their own stock exchanges as well so with the international market you can invest in companies from those countries. The third fund covers bonds, which are basically government and corporate money-raising programs. So with just these three funds an investor can invest in over 10,000 different assets and securities all over the world!
So why these three funds?
According to our definition from the last article, index funds just try to replicate an index (basically a really fancy Excel spreadsheet). These three funds are replicating the Total Stock Index, the Total International Index, and the Total Bond Index. That means they will never under-perform the market as a whole, since they represent the entire market. Also being index funds, they have low expense ratios. Remember, the expense ratio (MER) is the percent of your invested money that is charged in management fees. Index funds can have a very low MER because there is no need for a manager to pick stocks – it just follows the index. While actively managed funds can have expense ratios of 1-2%, Charles Schwab’s S&P 500 fund charges just 0.02%. 1/100th of the cost!
These funds also have several advantages: diversification (lots of different companies and asset classes), low turnover (less in taxes), and being easy to rebalance (since you only need to keep track of three funds).
Asset Allocation
Remember, asset allocation is the ratio of assets that you choose to hold. Since we are only talking about three funds, the ratio stays pretty simple. This is the ratio of American stocks to international stocks to bonds. What asset allocation should you have? A good starting point is 30% US Total Stock Market, 30% International Stock Market, and 40% total Bond Market. This follows the traditional 60/40 split between stocks and bonds. And it also splits US and international markets by weight since the US claims half of the entire world’s economy.
An advantage of deciding on a set asset allocation is that these three funds are not necessarily correlated. When stocks do well, bonds do not. If international stocks fall, US stocks could also fall or they could rise. When US stocks crater, US bonds go up. For example in March of 2020 when the stock market lost 30%, bonds went up 5%. This not only helps you weather storms, it also gives you a chance to make money. If in March of 2020 when your bonds are up 5%, you sold that extra 5% and used it to buy US stocks. Then in April when the stock market started to go back up you would have had that extra 5% increase in your investments.
Rebalancing
This is what is known as rebalancing. Rebalancing is when you sell some of your winners to purchase the funds that aren’t doing so hot. This may seem counterintuitive, but it allows you sell when asset prices are high and buy when they are on sale. This way you keep your desired asset allocation and survive through market crashes.
(As a note: I have very little in bonds right now as bond yields are so low. When they increase in a year or two I will start buying more bonds to get back to that 60/40 split. Also, if you are more than about 10 years away from retirement, I wouldn’t have 40% of my investment in bonds. I would focus more on pre-paying my mortgage or getting out of debt.)
So what funds should I actually invest in?
It depends on who you are investing with. While the funds are all basically the same since they replicate the same indexes, the actual ticker names are different.
For Vanguard the three funds are:
- VTSAX – Vanguard Total Stock Market Index Fund
- VTIAX – Vanguard Total International Stock Index Fund
- VBTLX – Vanguard Total Bond Market Fund
For Schwab they are:
- SWTSX – Schwab Total Stock Market Index Fund
- SWISX – Schwab International Index Fund
- SWAGX – Schwab U.S. Aggregate Bond Index Fund
For Fidelity you have options so that could be better or worse depending on how simple you want it:
- FZROX – Fidelity ZERO Total Market Index Fund, or FSKAX – Fidelity Total Market Index Fund
- FZILX – Fidelity ZERO International Index Fund, or FTIHX – Fidelity Total International Index Fund
- FXNAX – Fidelity U. S. Bond Index Fund
These are just three examples. I personally invest using Schwab and I have SWTSX, SWISX, and SWAGX. For Schwab’s Total Stock Market Index Fund (SWTSX) the expense ratio is 0.03%, their International Index Fund (SWISX) has an expense ratio of 0.06%, and their U.S. Aggregate Bond Index Fund (SWAGX) has an expense ratio of 0.04%. This means at a 30/30/40 split asset allocation, the average expense ratio is 0.043% meaning for every $1,000 invested I would pay $0.43 per year. This is why the Three Fund Portfolio out-performs nearly every professional investment portfolio, It’s simple enough that anyone can do it and it costs almost nothing in fees.
What do you think? Which funds are you invested in? Let us know in the comments below!
