Efficient Investing with the Three Fund Portfolio

I spent too much time early in my career trying to beat the market. I read a bunch of investment books and scoured the internet for trading tips. After all that work, my results were only mediocre. I wanted a to find a shortcut – investments that would make me a millionaire overnight. But more risk does not always come with more reward. I’ve found that the best way to invest is with a boring, yet highly effective and efficient Three Fund Portfolio.

Buying solid investments for the long term with the Three fund portfolio

Buying solid investments for the long term.

What is the Three Fund Portfolio?

The Three Fund Portfolio is a simple strategy to diversify across three broad asset classes. These include the US Total Stock Market, International Total Stock Market, and Total Bond Market. The portfolio can easily be created using low cost index funds which are now available with almost any brokerage company.

The total market index funds are diversified across the entire stock market and include a sampling of all companies, both large and small. The S&P500 for example is made up of the 500 largest US companies, whereas the Total Stock Market index fund is comprised of approximately 3,600 companies. It’s basically a slice of the entire US stock market.

The funds are cap weighted, meaning they own a portion of a company based on its value or market capitalization. If you had one company that was worth $10 billion and another worth $50 billion, you would end up owning 5 times more of the bigger company. For this reason the top 10 largest companies make up around 16% of the total market index fund.

It’s good to diversify.

The Three Fund Portfolio saves time

Investing in individual stocks can be a job in itself. If you want to have good diversification, you will be buying dozens if not hundreds of individual stocks. The fortunes and prospects for these companies can change day to day. You need to track the performance outlook of each investment on a regular basis. Basically you end up doing the work of a mutual fund manager.

I’m not interested in being a fund manager. I want to spend my time fishing, surfing, brewing beer, gardening, raising chickens, tinkering, and even chopping firewood. I’ve spent enough time in front of a computer doing research, and it’s the last thing I want to do in retirement.

The Three Fund Portfolio is low stress

Stress can easily encompass the mind, following you around and occupying mental bandwidth. The market is unpredictable and volatile. I don’t want to stress about whether I chose the right stocks to buy while I’m on vacation. I’ve been there and it sucks. Just like I don’t want my body trapped in a cubicle, I don’t want my mind trapped by needless stress.

When investing with a Three Fund Portfolio, I know I’m diversified across all markets. I own a stake in every major company, including bread and butter companies that feed and clothe us as well as the new and exciting companies that are forging our future.

I don’t want investment anxiety occupying my mind.

With the Three Fund Portfolio, there is nothing more I can do, or need to do. In fact, the best thing to do is relax, ignore the news, and enjoy life. The highly educated, and highly paid CEOs and managers of the world are worrying about my investments for me.

The Three Fund Portfolio is effective

As hard as they try, the majority of mutual fund managers and hedge fund managers can’t beat the market, especially when you account for their fees. Maybe I could do marginally better than the market through researching and buying solid investments. But if I wanted to sit in front of a computer for more money, I could get better returns going back to work as an engineer.

While you have a chance of beating the market with individual stocks, you are also taking on more risk. And more risk doesn’t always mean more reward, only that more reward is possible. It’s also quite possible you will under perform the market. If you count the cost of your own time, then you are looking at a less attractive proposition.

It's hard to beat the index and the Three Fund Portfolio

It’s hard to beat the index.

A Three Fund Portfolio is tax efficient

Index funds are very tax efficient because they only trade stocks as they enter and leave the minimum market cap. This means, when they are selling a stock, it’s on its way down, and in some cases the sale might even be at a loss. Usually any capital gains from selling can be offset with those capital losses. For this reason, the Vanguard Total Stock Market Index Fund has distributed zero capital gains to investors in over a decade. It’s almost like free built-in tax loss harvesting as they sell the losers and replace them with winners. As long as you leave the money invested, you only pay taxes on dividends, not growth.

US companies do business internationally, do I need international stocks?

The US stock market has crushed the international stock market over the last 10 years. But this wasn’t always the case, there have been many times where the international stock market has outperformed the US stock market.

The Three Fund Portfolio is all about reducing risk and optimizing gains through diversification. We buy the Total Stock Market index fund because it contains both large and small companies. This is because often times the small cap companies outperform the large cap companies like those in the S&P500. The same logic applies to purchasing the Total International Stock Market index fund.

You never know when the US stock market might under-perform, and right now it’s had a massive run up. The PE ratio for the US Total Stock Market index is 24.1 and the PE ratio for the International Stock Market index is 21.1 suggesting better value in international stocks. It’s not a big portion of our portfolio, but we do like having some international exposure.

How should I balance my Three Fund Portfolio mix?

The balance between the asset classes in the Three Fund Portfolio are going to be different for everyone. This can depend on things like your risk tolerance and how many years you have until retirement. A good place to start is by choosing a Vanguard Target Retirement fund based on your expected retirement date and take a look at its holdings. It’s not surprising to see that the Target date retirement funds are made up of US and International stocks and bonds – kinda like a three fund portfolio.

Target retirement fund allocations can give a good starting point.

Simply buying target retirement funds is in fact an excellent option. However, the fees are slightly higher, and you might want to balance your three fund portfolio across multiple accounts. The interest from bonds is taxed at the higher income tax rate whereas the stocks are taxed at the lower capital gains rate. For optimal tax efficiency, you can keep your bond allocation in your tax advantaged 401k. Then only keep stocks in your after tax brokerage account.

The Three Fund Portfolio works

While I still use a few other investment vehicles, the Three Fund Portfolio has done most of the heavy lifting on our journey to financial independence. I still like to read up on investing and search for better returns, but I always come back to the same conclusion. It’s hard to beat the efficient, effective, low maintenance, and stress-free Three Fund Portfolio.

44 thoughts on “Efficient Investing with the Three Fund Portfolio

  1. Ahh, sounds like a great method to diversify your investments. 🙂 Very, very few people are able to beat the market with regular trading; my goal is always to think long-term with investments and not get distracted.

    • It’s an easy way to diversify, and I find having my investments in index funds helps me stay out of the loop and just let them grow. Which is best for both me and my investments 🙂

  2. My wife and I retired in January with a similar portfolio. A mix of Vanguards VTI, BND, and a couple of retirement dated funds. We also originated a couple of notes on two parcels of property we sold. The notes pay $27000 annually and we have a little too much cash on hand so we don’t think we will need to withdraw from the portfolio for a couple of years.
    Tried the stock picking route years ago, way to much work. Indexed 100% today.

  3. The fact that the 3 fund portfolio has such an impressive historical performance as well as the fact that it requires a minimal amount of work to maintain really makes it the best of both worlds – low stress, high return. I can’t think of a better investing strategy.

  4. “Just like I don’t want my body trapped in a cubicle, I don’t want my mind trapped by needless stress.”

    This a good reminder that freedom is more than just financial and physical… it is mental/emotional as well!

    • That’s right, I think its important to take into account both physical and mental costs. I’ve seen better returns and have spent much less mental/emotional energy using index funds 🙂

  5. I’m with you, Mr. CK.

    Not long ago, I untangled a professionally managed mess of 28 funds, most of which had expenses exceeding 10 times what a good index fund costs, and transferred it all into a self-managed three fund portfolio.

    That couple will save $20,000 a year by owning a three fund portfolio, and will likely see better returns.

    Cheers to your diverse beers!

  6. Definitely the simple solution. Honestly I tend to run 4-5 funds per account. Per account because the fund provider is optimized to the options of the investment account. So for example what offerings are in my 401k and is the brokerage offering commission free on their products versus my individual account. 4-5 comes in because I prefer to split my small and large cap so I can tilt a bit more towards small cap then normal for the market.

    • I also have a few more funds than just 3. I have a similar deal with my retirement account splitting up large and small cap funds. My allocations also end up varying a little from a strict 3 fund allocation. It’s called personal finance for a reason 🙂

  7. The other great advantage of the three fund portfolio is that it makes investing seem accessible to wet-behind-the-ears-terrifed-of-everything new investors. I know I probably would have had a tough time jumping in if I had to pick stocks and bonds on my own. I started with the 3 funds, but now have a slightly more complicated portfolio because I also own REITs.

  8. Yes, because the highly educated, and highly paid CEOs and managers of the world are worrying about fund investments, so that we can relax, ignore the news, and enjoy life.
    So far, I still believe fund portfolio is the best investment vehicle for me. Every night, I only spend half an hour to check my fund portfolio. It is easy to manage.

  9. So! Where you invest (brokerage house) is important for the fees they charge but more important is what you invest in (ETF’s, Bonds, Reit, etc.). In the past I may have had the where right but not the what! Thanks for the heads up!

  10. Thanks for sharing, Mr. CK. I like reading your explanation for having the international funds. International makes up a smaller percentage of our portfolio. We are pretty heavily invested in US index funds with about 20% in bonds. You’ve convinced me we need to diversify a little more.

    • Yeah, it’s hard to get into international stocks looking at the last 10 years. But you never know what the future holds, and half the big companies are outside of the US. I take comfort that the experts at Vanguard prescribe it as well 🙂

  11. I agree that you dont need a lot of funds or a complex portfolio to invest successfully. Mostly, I’ve just set my contributions on automatic for many years and the results have been pretty great with minimal effort or concern. Any market timing I’ve tried to do has generally worked against me. When you factor in any time, effort, and worry it doesnt seem worth it and probably wont give you any real edge over the long term. Like you mention, if you want a better return you’ll probably do better just going back to work instead of spending a lot of time trying to beat the market.

    • My efforts trying to time the market only worked against me as well. It’s been much better for me and my investments when I stay out of the loop. Automating contributions to a simple portfolio worked well for us 🙂

  12. Unfortunately, I don’t have a total stock market index fund available to me in my retirement accounts at work. I make up for it by doing an S&P500, Midcap and Small-Cap index. I would love it the other way, but it does provide some diversity

  13. Shortly after I opened my Roth IRA I went to this method and it has worked well for me. Whenever I put in my contributions I buy what I need to keep my allocations where I want and forget about it until I put in my next contribution. Well maybe not completely forget since I check my network monthly but still it is stress free and easy!

  14. Great post! I do something very similar with national and international shares. I do have a couple of individual stocks I bought a while ago, but all new proceeds are going into the two main funds. Keeps it simple, instantly diversified and way less paperwork for the tax man.
    I hope more people find your advice and aren’t afraid to jump in and try something simple – investing doesn’t have to be complicated.

    • The simplification is a great aspect of it. I closed down my trading account, making for one less tax form, and one less account to check up on. Investing doesn’t have to be complicated 🙂

  15. I also used to pick random stocks, 20% winners / 80% losers. Luckily for me 1 winner is carrying the load at the moment.. but thats scary.

    Next I got on the 60% stocks /40% bonds strategy but bought way too many funds. (my brokerage loved me and the fees I paid)

    From now on I’m all about that total market fund life! Live and learn.

    Less is usually more, great article.

    Like the blog, like the looks of your lifestyle you’ve created!


    • Yeah, I spent a lot of time chasing individual investments, and didn’t ever have much to show for it. This is easy and performance has been better than what I did myself. I’m also really happy I don’t have to stress out about investments anymore 🙂


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  17. I like the approach but I am a little confused? If I use crude math and the prescribed percentages I get a 10 year average return of about 2.2%? If I add in dividends I think that might get it closer to 4% but it seems that in an effort to lower costs and make investing easier you are leaving a lot on the table. Maybe invest in a global balanced fund? You would pay a management fee of about 1% but your 10 year average return would have been over 13%. No stress, let the pros do what they do best and exposure to all 3 areas.

    • Hi John,

      The percentages in the pie graph are just from a Vanguard 2035 target retirement fund, and the 10 year return on that fund is currently 5.46%. I don’t see any global management fund with the kind of returns you are suggesting.

      Those mutual funds are usually made up of the same pieces of the market. If they manage to beat the market, it’s only for a short lived period. The only thing the pros can guarantee is that you’ll be paying them their 1% yearly fee, and sometimes much more.

      If you really wanted to be lazy, simply buying into a target retirement fund will do. But for tax purposes I recommend keeping bonds and stocks in different accounts as I mentioned in the article.

      Hope this helps 🙂

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