Investments

What Is A Boglehead

By David Krug David Krug is the CEO & President of Bankovia. He's a lifelong expat who has lived in the Philippines, Mexico, Thailand, and Colombia. When he's not reading about cryptocurrencies, he's researching the latest personal finance software. 11 minute read

In the United States, investing is rarely discussed publicly in social circles or taught in schools, so most new investors must teach themselves how to choose stocks and bonds through a combination of online resources and trial and error. But the costs of making mistakes can be high.

There are now institutional-quality funds available that eliminate a lot of the learning curve. These mutual funds, exchange-traded funds (ETFs), and index funds provide diversified portfolios of equities selected by some of Wall Street’s most acclaimed analysts.

Furthermore, many prebuilt portfolios have been created to help investors even novices get started with investing with minimal effort. The Bogleheads Three-Fund Portfolio is a common example of such a portfolio.

What Exactly Is a Three-Fund Portfolio for Bogleheads?

When it comes to passive investment strategies, the Bogleheads Three-Fund Portfolio is among the worst offenders. One of the simplest portfolios to set up and manage, as its name suggests, the Three Fund Portfolio consists of just those three investment-grade funds.

The idea is to reduce risk while still gaining exposure to the general stock market’s returns by purchasing shares in three low-cost, highly diversified index funds: one that invests in U.S. equities, one that invests in overseas companies, and one that invests in U.S. bonds.
John C. Bogle, well known by his nickname “Jack,” created the investment portfolio. 

Prominent as the founder of Vanguard, a firm that oversees over $7 trillion in assets, he is a famous fund manager.

For those interested in learning more about the concepts Jack uses when making investment decisions, Bogle also established the popular investing forum Bogleheads.org. The three-fund portfolio was also introduced there.

Asset allocation in a portfolio

The asset allocation in this portfolio is not predetermined, making it unique among prebuilt portfolios. It’s more of a guide to creating a portfolio that works for you specifically. 

Specifically, the portfolio is made up of the following three asset categories:

  • Stocks are traded in the United States. Most of the portfolio is invested in an index fund that provides broad exposure to the U.S. stock market, and this strategy is recommended for those with a long-term investment horizon. To track the overall performance of the U.S. stock market, you may invest in a fund that tracks the S&P 500, the Russell 3000, or any other index.
  • Foreign Investing. Your next investment will be in foreign stocks. You can acquire exposure to these assets by purchasing a total international index fund, which invests in a wide range of securities issued by companies based in both developed and emerging markets outside the United States.
  • Treasury Bonds of the United States. At last, there’s a stake in a U.S. bond-focused index fund in the portfolio. Ideally, this bond index fund would have a variety of different maturities of bonds.

However, Jack Bogle recommends considering your investing horizon when deciding how much of your portfolio to devote to each asset class. The most effective method for doing so is to allocate as much as your age in bonds, and then divide the remainder between domestic and overseas stocks.

If you’re 25 years old, one possible investment strategy is to allocate 25% of your portfolio to U.S. bonds and the other 60% to a mix of U.S. and overseas equities.

Diversification Is Important, Right?

Completely! Spreading your money across reduces your exposure to any one market’s fluctuations. If this were a portfolio of stocks and bonds held separately, the three assets would not be enough to provide adequate diversification.

Though small in number, the portfolio still maintains a high level of diversification thanks to its composition of three index funds, each of which contains hundreds, if not thousands, of stocks.

Behind the Portfolio’s Investment Thesis

The three-fund portfolio is meant to simplify investing while yet giving investors access to the wealth-building potential of the U.S. and worldwide stock markets. Adding bonds to the portfolio will also reduce the overall level of risk.

According to Taylor Larimore, author of “The King of Bogleheads,” “The Bogleheads’ Guide to Investing,” and “The Bogleheads’ Guide to the Three-Fund Portfolio,” the portfolio may be easy to implement and manage, but the underlying theory is highly complicated.

According to Larimore, a portfolio constructed with total market index funds will include more than 10,000 securities from throughout the world, representing a wide range of market capitalizations and industries. In addition, the portfolio’s structure results in relatively low expenses overall, both in terms of fees and tax efficiency.

This portfolio does not suffer from style drift or overlap because it is built on top of a broad market index. As a result, your portfolio is less likely to deviate from your desired investment strategy or to contain assets that duplicate those of another holding. Further, rebalancing is uncomplicated because there are so few funds involved.

The premise of the investment is to mimic the market’s behavior as closely as possible in order to maximize the benefits of diversification and exposure to assets.

Advantages and disadvantages of a Three-Fund Portfolio

The three-fund portfolio is like any other investment strategy in that it has advantages and disadvantages. Before putting your money into this plan of action, think about the following advantages and disadvantages.

Advantages of a Three-Fund Portfolio

The three-fund portfolio has extra advantages. Notable examples of these are:

1. Significant Diversification

The portfolio consists of just three funds, but because they are so widely diversified, your holdings will be quite diverse.

That’s a tremendous plus because lowering your vulnerability to market swings and big losses should one or more asset classes underperform is one of the main reasons to diversify your portfolio.

2. Low Cost

The bulk of the portfolio is made up of low-cost index funds, such as those provided by Vanguard, a fund manager noted for its relatively low expense ratios. Investment costs are inevitable, but minimizing them means keeping more of your hard-earned money in your portfolio over the long term.

3. A Basic Method

Every level of investor can find success with this portfolio. After all, this technique employs a method of investing that is about as basic as it gets. This makes it an attractive choice for inexperienced traders as well as seasoned investors who lack the time or interest to implement more involved techniques.

Disadvantages of a Three-Fund Portfolio

Despite the fact that the three-fund portfolio has a lot going for it, there are certain disadvantages to think about first. 

To name a few of the most notable:

1. Having no control

Investing in three different index funds is what this portfolio recommends. Because of this, you will no longer have any say over the exact investments your portfolio makes or the actions taken on your behalf in the event of shareholder votes; instead, it will be up to the fund managers to do so.

2. There is No Chance to Beat the Market

Some investors choose the lower risk, while others are ready to take on more uncertainty for the chance for bigger rewards. The standard three-fund portfolio approach won’t satisfy your need. If your portfolio is meant to replicate the market performance, you have very little chance of outperforming the market.

3. One-for-the-Other Diversity

If you wish to invest in all three overseas equities, small-cap companies, and real estate, you’ll be too far from the principles of this portfolio to call it a three-fund investment, despite the fact that doing so would give you substantial diversification.

However, you can still use the underlying ideas to tailor the approach to your specific circumstances. Instead of dividing your stock allocation between domestic and foreign equities, you might diversify your holdings among five funds, including large- and small-cap stocks, as well as real estate.

Who Should Use the Three-Fund Portfolio from Bogleheads?

Choosing which funds to include and how much to invest in each one is largely up to you, making the three-fund portfolio model as close as it gets to being a one-size-fits-all investment strategy as possible.

If I had to offer you a big list of people who should employ this method, it would be much easy to tell you who shouldn’t.

This portfolio may not be for you if you don’t fit any of the following descriptions. You’ll be in good hands if you stick to the three-fund strategy, anyway.

No Need to Outperform the Market

You shouldn’t expect to outperform the market with this portfolio. Instead, it is meant to give you diversified enough exposure that your returns will be in line with the market as a whole.

This is not the approach to take if you are an investor who is willing to take some calculated risks in search of alpha. But the three-fund portfolio has you covered if you’re content with the market average return over the long run in exchange for lower volatility and greater diversification.

No Desire to Choose or Manage Individual Investments

This technique, and any strategy based on investing in funds, is not a good choice if you desire complete discretion over your portfolio’s management.

When you put your money into a mutual fund, the managers get to decide not only which stocks you buy, but also whether or not you get a vote based on the number of shares you hold.

However, many investors are content to let professionals handle stock selection and have little desire to participate in shareholder voting on corporate policies.

How to Recreate the Three-Fund Portfolio from Bogleheads

The Bogleheads Three-Fund Portfolio is simple to reproduce in your own brokerage account using low-cost ETFs due to its reliance on just three broad-market index funds. Do not take the below-mentioned investments as gospel. 

The method recommends spreading your money across a variety of asset classes, including domestic and foreign stocks as well as bonds, but the specific funds you choose to allocate to each are up to you.

For this illustration, the portfolios with total stock market index assets that are indicated below are the most diversified possibilities.

Additionally, the three-fund portfolio, like any other portfolio, can be tailored to meet your specific requirements. Those who choose to stick to domestic investments can see instances of this portfolio that avoid the more common practice of investing in foreign assets.

Using the Customary Three-Fund Portfolio

Putting together the standard Bogleheads 3-Fund Portfolio is a breeze, and you may do so with the following stocks:

  • The Vanguard Total Stock Market Index Fund (VTSAX). The VTSAX’s primary function is to provide a proxy for the entire U.S. market. It consists of thousands of domestic equities from a wide variety of industries and market capitalizations. This fund’s expense ratio is extremely low at only 0.04%, and it provides investors with exposure to both growth and value equities.
  • Fund of Indexed International Stocks from Vanguard (VTIAX). The VTIAX provides exposure to a wide range of international equity markets. It also diversifies by investing in stocks across the market cap and industry spectrums, with an emphasis on value. In contrast, all of these stocks are issued by multinational corporations with operations in both developed and developing nations. The fund has a lower expense ratio than the VTSAX fund, at 0.11%, but it is still significantly cheaper than the average mutual fund.
  • Investment Company Issued by Vanguard Group Inc. That Tracks the Total Bond Market Index (VBTLX). In the end, the conventional portfolio includes a bond fund such as VBTLX, a diversified portfolio of U.S. debt instruments like Treasury investments, mortgage-backed securities, and other bonds. Bonds come in a wide variety of forms, with maturities spanning from the very short to the very long term.

Modified three-fund portfolios are available to domestic investors only.

The three-fund portfolio can be adjusted to suit your needs if you prefer to invest solely in domestic securities.

The portfolio’s current international asset mix might be shifted to local investments with a comparable risk-reward profile, and there are two attractive alternatives. The real estate market and stocks in smaller companies fall within this category.

Option #1: Little-Cap Stocks

You should continue to put money into VTSAX and VBTLX, as you would with a conventional portfolio if you want to reap the benefits of the small-cap approach. In contrast to VTIAX, which invests in foreign stocks, the Vanguard Small-Cap Index Fund focuses on domestic companies (VSMAX).

Small-cap stocks from a variety of U.S. corporations across industries are represented in this portfolio. The fund’s expense ratio is 0.05%, which is extremely cheap compared to similar options.

In the United States, small-cap stocks have historically outperformed their large-cap counterparts for the same reason that many foreign equities do: they offer significant growth potential in relatively untapped domestic markets.

However, the lack of a demonstrated history of success makes investing in these firms riskier than usual, making them comparable to investing in foreign stock options in terms of potential payoff against potential loss.

Option #2: Property Investment Trust (REITs)

To compensate for the loss of diversification caused by selling off foreign holdings, the Vanguard Real Estate ETF might be added to the portfolio (VNQ). This pool of capital is put toward the purchase of commercial real estates such as hotels and office buildings.

This fund has a very low-cost ratio of 0.12%. It’s the most expensive of the funds we’ve discussed so far, but it’s still far cheaper than the market average of 0.44%.

While real estate investment trusts (REITs) have historically generated excellent returns, they also carry a higher level of uncertainty. After all, rental income is the sole source of profit for these trusts’ real estate holdings. The potential rewards are also very similar to those of foreign stocks in this regard.

Keep Your Portfolio Balanced

It’s crucial to strike a balance in your investment portfolio, no matter how basic or complexes it may be. After all, an investment strategy is useless unless it is implemented. In the three-fund portfolio, you can be lazy and only rebalance your investments quarterly rather than every week or even every month.

Make sure the proportions of your portfolio’s total value invested in each of the three funds still reflect your original allocation strategy. 

If you’re 25 years old and your portfolio currently consists of 42% U.S. stocks, 40% international stocks, and only 18% bonds due to the impressive growth of your stocks but the lackluster performance of your bonds, you might consider selling some of your U.S. stocks and international stocks and reinvesting the proceeds in more bonds.

This would allow the portfolio to continue to provide the level of protection against volatility for which it was intended.

Bottom Line

As a whole, the three-fund portfolio is a popular choice for both new and experienced investors. The portfolio gives you exposure to the market as a whole while maintaining a risk-to-reward ratio that takes your time horizon into account.

The portfolio can be adjusted to meet the needs of most investors, but it is not a one size fits all solution. In addition, prior to implementing the approach, it is recommended that you conduct research to determine which funds are best suited to achieve your investing goals.

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