For many new investors, the stock market can be a vast and confusing place. There are so many different investment options available, that it can be scary to take the first step. Even armed with some basic investment knowledge, many beginners don’t think they know enough to invest money or will be able to find the right investments with stock picking\individual stocks.
If this sounds like you, then the three-fund portfolio may be for you. This is a very simple strategy to invest your money that will get you into the investing game and headed in the right direction.
What is the 3 Fund Portfolio?
The three-fund portfolio is a very simplistic investment strategy. For all the investment options out there, the stock market can mostly be boiled down to three main categories. Domestic stocks, International stocks, and bonds. Using these three main categories as a guide, the three fund portfolio aims to take advantage of all three by investing in one fund that focuses on each of the investment categories.
Who is the 3 Fund Portfolio For?
The three-fund portfolio can really be implemented by anybody. Also called the “Lazy Portfolio”, this investing strategy is mostly for those of us who really want to invest, but don’t want to spend a lot of time and effort doing it. This is also commonly known as passive investing. By using a simplified strategy like this, the investor can be “lazy” and really use more of a “set it and forget it” method of investing.
The other main use of the three fund portfolio might be a new investor looking to open a brokerage account or other investment account. As mentioned, the stock market can be an intimidating place for new investors, and keeping it simple is a great way to get started. Once you’ve been able to get your feet wet with the three fund portfolio you can always choose to continue on with it or venture out into new methods of investing as well.
Why Use the 3 Fund Portfolio?
There are a few reasons you might want to consider a simple investment strategy such as this. As mentioned already, a big reason is its simplicity. Don’t mistake simple for ineffective though. Just because you’re not out chasing stocks, doesn’t mean you won’t see good returns. Because the three fund investment portfolio invests in the three main areas of the stock market, you’ll see good returns no matter which sector is doing well. This is due to the diversification of stocks and bonds within the strategy. Almost every investor will tell you that having a diversified portfolio is essential when investing. Basically the equivalent to “don’t put all your eggs in one basket”, spreading your assets across the domestic stocks, international stocks, and bonds, will expose you to a broad part of the market and will keep the volatility of your portfolio at a relatively low level.
Another big factor of why you should use the 3 fund portfolio is because it encourages the use of index funds. Index funds are not actively managed like mutual funds or ETFs(Exchange-traded funds) are and are considered to be low risk. Index funds will have much lower net expense ratios (management fees) as well. Historically speaking, over the long term, having an actively managed portfolio by including managed funds won’t outperform index funds, making the low-cost index funds even more attractive. They won’t have a high yield, but they are great long term investments and with compounding on your side, you can’t go wrong with index funds.
Although the difference in fees may look like a small percentage, that could add up to tens of thousands of dollars over the course of an investing career of 20 to 30 years. No matter who you use, there will always be a variety of index funds. Vanguard, Schwab, T. Rowe Price, and Fidelity, for example, all have their own index funds covering the total stock market.
Finally, time is a big factor in using the 3 fund portfolio as well. Many people are extremely busy these days and figuring out their next few trades isn’t always at the top of their list. Once you’ve implemented your investments in this strategy, you can simply set automatic contributions each month and let them go until you’re ready to take a look again.
How to Start Using the 3 Fund Portfolio
Now that we’ve gotten the basics down, it’s time to figure out how to implement the 3 fund strategy. For as simple as it is, you shouldn’t blindly find the first three index funds you come across and call it a day, there is some prep work to be done here.
Figure out your goals – As with anything you invest in, before doing anything you should figure out what you want out of this investment. Do you want safe low investment returns or do you want to get a little bit riskier? Or do you want to take even bigger risks? When determining this, also take into account the time frame of the investment. If you are young and have 30 years before you’ll need this money back, riskier is typically the way to go. If you are closer to retirement and are just looking to beef up your retirement savings(IRA or 401k) and you don’t want to lose money, then playing it safe might be for you.
Determine Your Allocations – Once you’ve figured out how much investment risk you are willing to take, you can figure out how much of your funds you can allocate to each sector of the portfolio. If you are leaning towards safer investments you will want to allocate more towards an index fund that mostly invests in bonds. If you are looking to get bigger returns and take on more risk, shift more of your funds across the domestic and international stock index funds.
To give you an idea of how you might allocate your funds, you can apply other common investing allocations according to one’s risk tolerance:
Aggressive Allocation – Having 80% in stocks and 20% in bonds
Moderate Allocation- Between 50-60% in stocks and 30-40% in bonds
Conservative Allocation – Having 20% in stocks and 80% in bonds
Make it Automatic – Once you’ve made your initial investment, don’t forget to make future investments automatically. It’s incredibly easy to get to allocate money elsewhere and struggle to make the same investment manually every month. You’ll always have something else you want to spend the money on. Don’t tempt yourself. It’s just as hard to stop an automatic investment so set that up and don’t look back.
4% rule – The 4% rule has been popular for about 30 years now. Basically, it’s a loose rule saying that when determining your retirement income, if you withdraw 4% of your investments each year, you’ll have enough to live off of for about 30 years. When determining how to implement the three fund portfolio, you’ll need to determine if 4% withdrawals of your investments will be enough to live or if you’ll want to withdraw higher amounts. If you need to boost returns or are looking to withdraw more, you’ll need to allocate your money into the three funds accordingly.
Remember to Rebalance
One of the biggest advantages of the “lazy portfolio” is being able to set it and forget it, but that doesn’t mean ignoring it. Periodically check-in when you can for rebalancing. Maybe that’s every few months, once a year, or maybe more, but no you should never leave any investment unchecked for too long. Financial situations change and priorities shift, and when they do, you need to update your allocations or maybe even one of your investment funds completely. Don’t be afraid to move funds around to best suit your long-term goals and needs.
Investing in the stock market is a great way to grow your money. You might be saving for retirement, investing for college savings, or just a nest egg. The three fund portfolio is one of the investment strategies many investors can use to start investing or simply be a “lazy investor”, but the important thing is to be invested in the first place. You can always start off using this strategy and diversify into new options after gaining the necessary knowledge and confidence. Even with its simplicity, make sure you do your research before investing using this strategy too.
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Jeff is a fan of all things finance. When he’s not out there changing the world with his blog, you can find him on a run, a Mets game, playing video games, or just playing around with his kids.