In the previous posts of the Investing series, we have covered the basics of the stocks and bonds. We also have covered index funds, in the form of mutual funds and Exchange Traded Funds (ETFs). You should now have a good idea of how you want to invest. The problem remains on how to invest! One solution to this problem is the Three-Fund-Portfolio.
This is a very important question and one that you should spend some time thinking about. There is no one-size-fits-all investment in my opinion. There are many kinds of investment that work. For some of them, you will need some knowledge and time to make it work. The three-fund portfolio is a very simple portfolio made of three funds that should work for most people.
In this post, we are going to cover two things. How much bonds you should have and what is the Three-Fund Portfolio. Since there are also some direct variations of the three-fund portfolio, I am also going to cover them!
Allocation to bonds
Before we go into details of the three-fund portfolio itself, there is something else we need to cover. We have covered bonds before. They are a safer investment than stocks, but they are not risk-free. And they have historically seen worse returns than stocks. People are using bonds in a portfolio to reduce its risk and its volatility.
There is a general rule of thumb in the community. That is to use your age in bonds allocation. If you are 40 years old, you allocate 40% of your portfolio to bonds. This is a good rule of thumb. But it is not more than this. And it is quite conservative in my opinion. Most young people do not need that large bond allocation in a portfolio. If you feel you want more bonds, you should go for it. If you feel you do not need bonds there is nothing wrong with it. There are several personal finance bloggers that do not use bonds. In that case, you should be ready for greater volatility.
Personally, I do not own bonds. For several reasons. First, Swiss bonds are really bad. Currently, Swiss bonds have a negative yield. So you are guaranteed to lose money on this investment. I would strongly advise using this investment. Cash is a better investment now. Secondly, I have a large pension (my second pillar). This pension is not aggressively invested. I can basically expect no return on this money. Therefore, I consider my state pension as bonds. That means I do not really need more bonds. Finally, I want to take an aggressive approach for now since I am still young and I can afford it. I may change my allocation to bonds in the future.
In the end, it is always up to you. If you have access to better bonds like U.S. bonds, you can consider adding some bonds to your portfolio. Do not make the same mistake I did and invest a very low amount to bonds. Less than 10% invested in bonds is not worth it. Either you invest zero in bonds like I do or you invest at least 10%.
The Three-Fund Portfolio
The three-fund portfolio, as its name indicates, is a portfolio made of only three funds:
- A domestic bond fund. For instance, Vanguard Total Bond Market ETF (BND).
- A domestic stock fund. For instance, Vanguard Total Stock Market ETF (VTI).
- An international stock fund. For instance, Vanguard FTSE All-World ex-US ETF (VEU)
With this portfolio, you have domestic stocks, international stocks and bonds in your portfolio. This a great simple way to have diversity in the different assets and in the different countries. This advised in several books, for instance in The Bogleheads guide to investing.
The allocation of bonds is easy, it is the one you chose in the previous section. Then for the remaining, it is up to you. There are several models, but no global agreement. You can go 50% domestic and 50% international. Or you can go 75% domestic and 25% international. In my opinion, it mostly depends how much our country represents of the global market. If you are in the U.S., I feel like 50% or even 75% makes sense. But it would not make sense for Switzerland.
For instance, if you have decided to go with 40% of bonds. You can follow the 50% route and allocate 30% of your portfolio to domestic stocks. And 30% of your portfolio to international stocks. Or you can go the 75% way and allocate 45% to domestic stocks and only 15% to international stocks.
Three-fund Portfolio outside of the U.S.
Now, the three-fund portfolio was first devised for the United States. If you are not, like me, in the US, you will probably have to adapt a bit your system. The U.S. are a special case because their stock market makes a large part of the entire world stock market. That means that your domestic stocks investment will be very diversified. On the other hand, Switzerland stock market is 2.5% of the entire stock market. So it makes less sense to allocate a large part of your portfolio to your home country.
I would say that the allocation to domestic and international will strongly depend on how well your domestic stock market is doing. And also how big it is.
Personally, I allocate 20% of my portfolio to Swiss stocks using two well diversified index funds. I think at least 10% of domestic stocks make sense for most stock markets. You have to realize that this will probably be the only fund that is in your own currency. The other funds will be in foreign currencies. As such, this will cause more volatility.
The Two-Fund Portfolio
Another portfolio that is quite popular is the two-fund portfolio. There are more variants of this one. I do not think there is a single most popular version fo the two-funds portfolio.
The first version is simply the three-fund portfolio but without any bonds. If you do not intend on holding bonds, you will be left with a two-funds portfolio. You will hold one domestic stock fund and one international stock fund.
Some people also do not like to invest in international stocks. Therefore, they are back to the two-funds portfolio. They have a domestic bond fund and a domestic stock bond. I like to have international diversity. But that is mostly a matter of preference. Nobody can tell the future. But it is always a good idea to avoid having all your eggs in the same basket.
Finally, some people simply use a single fund for the domestic stock and international stock funds. There are funds that hold all the stocks in the entire world market. For instance, Vanguard Total World Stock ETF (VT). If you use a global world stock market and a domestic bond fund, you will have almost the same result as the three-fund portfolio. The main difference is that you cannot choose the allocation of domestic and international. But you will have a market-cap weighted allocation of domestic against international. Which is not bad!
The One-Fund Portfolio
Why not make even more simple? The simplest portfolio of all is the one-fund portfolio. There are many ways to create a one-fund portfolio. But I think the one that makes the most sense is a portfolio that has only a global world fund. Such as Vanguard Total World Stock ETF (VT). That means you will have stocks from every country in the world. This makes for a very simple portfolio to manage. And it is also great since you do not have to rebalance!
The only downside, in my opinion, is that you will likely have only foreign currency in your portfolio, likely USD. If you are in the US, then it is a not a big deal. You could also hedge against your home currency. But I do not think currency hedging makes a lot of sense for long-term investing.
Another one-fund portfolio is to simply hold the entire domestic market. I think it is worse than just holding the entire stock market, but it may be easier. You will have no currency risk. And you should know better into what you are investing. But if the domestic stock market completely crashes, you may to be able to withdraw for many years. Nevertheless, for the U.S., I think it is not such a bad idea to hold only the entire U.S. stock market.
You should now have a better idea of the kinds of portfolios that exist. The three-fund portfolio and its two and one funds variant are the most popular portfolio. They are also the most simple. That is why I chose to talk about them first. If you do not know a lot about investing, you should keep things simple. In one of the next posts of the series, I will try to talk about alternative portfolios. They are a bit more advanced but in the end, the results are similar.
Personally, my portfolio is close to a two-funds portfolio. I am allocating 80% of my portfolio to a world stock market fund. And the 20% are domestic. But I am using two funds for the domestic part. It may change in the future though.
If you want to read more information about the three-fund portfolio, you can read more on the Bogleheads Wiki.
What do you think about these portfolios ? What kind of portfolio are you using ?