Retirement planning can often feel like an unwanted experience of choice overload. Workplace 401(k)s typically serve up more than a dozen mutual funds you must choose from for your retirement investment portfolio. And if your retirement planning includes saving in an individual retirement account (IRA), you may have thousands of mutual funds at your fingertips.
Take a deep breath—you can get all the asset allocation and diversification you need with a three-fund portfolio. Yep, three funds are all it takes to ace your retirement savings.
What Is a 3-Fund Portfolio?
A three-fund portfolio is a simple—yet smart—way to create a diversified retirement savings plan by focusing on stocks (one U.S. fund and one international) and bonds (one U.S. fund).
Why that ratio? Over time, stocks have delivered better returns than high-quality bonds and cash. The annualized return for large U.S. stocks dating back to 1928 is around 8.5%, adjusted for inflation. Meanwhile, bonds, like 10-year U.S. Treasury notes, for instance, have provided inflation-adjusted annualized returns of 2.3%, according to data compiled by New York University professor Aswath Damodaran.
Each of these far outpaces cash’s long-term performance, which generally struggles to keep up with inflation. And adding in an international stock fund that includes companies in developed and emerging markets further diversifies your stock holdings while positioning you for growth potentially uncorrelated with the rest of the U.S. stock market.
But there’s a catch. (Of course.) While domestic and international stocks generally trend upwards, from time to time, stocks fall in value. Owning some bonds along with stocks can be a great way to calm your investing nerves during inevitable dips and bear markets. Quality bonds typically hold their ground when stocks fall and may even rise in value.
In short, you can get the growth of stocks and the calming protection of bonds with a three-fund approach.
Why Should You Build a 3-Fund Portfolio?
A three-fund approach is a bit of a Goldilocks solution. It gives you most of the diversification of an all-in-one solution, like a target date fund, where all the investments are chosen for you. But it also grants you more control over the investments you put your money in, which helps you craft an asset allocation that reflects your personal desired level of risk.
For example, if you are in your 20s or 30s, a target date fund tied to your expected retirement age will typically start you out with 90% invested in stocks. While that’s smart in the abstract (you’ve got decades until retirement, so you have plenty of time to ride out bear markets), it may make you too antsy during down periods. That’s where a personalized three-fund portfolio may come in handy.
On the flip side, you also need to consider whether it continues to be a good fit once you hit your 50s, says Beau Henderson, founder of RichLife Advisors in Gainesville, Ga.
A target date fund’s composition typically increases its bond holdings as retirement nears. A target date fund for those retiring in 2060 likely has just 10% or so invested in bonds, whereas one for those aiming for a 2025 retirement might have 40% or so riding on bonds.
“If 10 years out from retirement you review where you are at, and you are confident Social Security and a pension might cover most or all of your income needs in retirement, then maybe you don’t need the 40% or 50% bonds that are common in [target date funds] for people nearing retirement,” he says.
You could correct this discrepancy with a riskier mix in a three-fund portfolio.
Three-Fund Portfolio Disadvantages
If you go the three-fund route, you need to stay on top of your overall portfolio and handle rebalancing to ensure your portfolio retains the right mix of stock and bond funds as the market waxes and wanes. (Rebalancing is built into target date funds; you don’t have to do anything.)
And while a three-fund portfolio offers solid asset allocation, you may be missing out on a few other asset classes that can deliver another layer of diversification, such as real estate or gold, or adding some diversification to your bond holdings by owning a mutual fund that invests in Treasury Inflation-Protected Securities (TIPS).
Still, a three-fund portfolio is a retirement-savings example of how not to let the pursuit of the perfect be the enemy of the good. Trying to build and watch over a portfolio with lots of moving pieces can be a chore. The three-fund approach gives you plenty of diversification and more control than a one-fund approach.
How to Build a 3-Fund Portfolio
Here’s how to save for retirement using the three-fund strategy:
Decide on Your Asset Allocation Mix
It’s up to you to decide what percentage of your money you want to invest in your three funds.
The first step is to decide how much you want to invest in stocks and how much in bonds overall. The younger you are, the more you typically want to rely on stocks for long-term retirement savings. In your 20s and 30s, that generally translates to somewhere near 80% in stocks and 20% in bonds.
Chances are your workplace plan or the brokerage where your IRA has a free online tool to help you hash out the right asset allocation mix.
For the stock portion of your portfolio, you will need to make one more asset allocation choice: how much to invest in U.S. stocks and how much to allocate to international ones. Allan Roth, the founder of Wealth Logic, a financial advisory firm in Colorado Springs, Co., makes a case for a three-fund portfolio in his book “How a Second Grader Beat Wall Street.” He suggests allocating two-thirds of your stock portfolio to U.S. stocks and one-third to international ones.
Focus on Broad-Market Index Funds
“Your goal is to own the market, not beat the market,” says Henderson. Think that’s settling? It’s anything but. Morningstar’s annual review of active vs. passive funds shows that over the long term, very few actively managed funds, where professional investors handpick each investment, manage to do better than low-cost index funds that simply try to replicate the market’s overall performance.
A three-fund approach focuses on index funds that take a broad-market approach. Look for “total” in a fund name. For example, the Vanguard Total Stock Market Index fund owns U.S. large caps, mid caps, and small caps. That’s more diversified than the Vanguard 500 Index fund, which owns only the large caps in the S&P 500 stock index.
There are also general total market index international stock funds and “total” bond funds.
Keep Your Costs Low
Most mutual funds and ETFs charge an annual fee called an expense ratio. “Fees are the one thing totally in your control,” says Henderson. “It’s easy and important to use low-cost index funds.” The higher the fee, the less money you have to grow and compound over time.
Be sure to Rebalance
From time to time, you will need to check if the performance of your funds has caused your portfolio’s asset allocation to stray from your target. For example, after a strong run for stocks, you may find that your intended 80%/20% mix of stocks and bonds is now 90%/10%. You can get back to your desired asset allocation by selling shares of the fund that has grown too big and reinvesting shares in the fund(s) that are lighter than your target. As you near your target retirement date, you’ll need to perform similar maintenance as your asset allocation changes.
Note: When you exchange shares within a retirement account—401(k) or IRA—there is no tax on your gains.
Alternatives to the 3-Fund Portfolio
If all that three-fund work caused your eyes to start glazing over, one fund, such as a target date fund, maybe the right choice.
Or, for younger investors who are sure they don’t need a slug of bonds for when stocks are tanking, Henderson says a two-fund portfolio that is divided between U.S. stocks and international stocks is a solid option.
That can also work for older investors who are confident that they can cover their retirement living expenses from guaranteed income sources such as Social Security and a pension and prefer to keep their retirement portfolio focused on long-term growth.
