Can you be a successful investor with just three funds?

 

Investors have more choices about where to put their money than ever before. There is a wide range of available stocks and bonds, as well as mutual funds, including exchange-traded funds, that combine those two basic vehicles. Add in options, futures and other derivatives, and there is no end to the different kinds of portfolios available.

There are questions about whether or not all of these elements are really necessary for a successful portfolio. Certainly there is a case for ownership of individual stocks or bonds, but a group of people who call themselves “Bogleheads” (after Vanguard Group founder John Bogle, the father of index investing) has argued that three mutual funds or ETFs can provide enough diversification to make up a well-balanced portfolio.

Owning only three funds would certainly cut down on the time it takes to review your portfolio statements, but is a portfolio of just three funds really a good idea? Managing Editor Bobby Raines and Analyst Julian Close debated the issue recently.

Bobby: I think the Bogleheads are basically right on this one. The original suggestion was three Vanguard funds: one that tracks a total U.S. stock market index, one that tracks an international stock index that excludes U.S. stocks and one that tracks investment-grade taxable U.S. bonds. The suggestion was to put 40% in U.S. stocks, 20% in international stocks and the remaining 40% in the bond fund. That gives this portfolio the 60/40 split that is pretty much the industry standard for a well-balanced portfolio.

Picking a broad U.S. stock fund gives you exposure to the stock market in the world’s largest economy, while spreading your investment around enough that you won’t be hurt if any one stock or industry stumbles. The non-U.S. international stock fund gives you exposure to both emerging markets and the more developed economies in Europe and again, spreads the money around as protection against trouble in any particular place.

A U.S. investment-grade bond fund does exactly what any fixed- income asset should do, provide a steady place to put some money to protect against the volatility that is more typically found in equity markets, while also providing a steady, if slower, rate of return. What’s not to like?

Julian: What’s not to like is a good question, and I respond by asking, what’s not to like about a stylish, great-looking brand-new suit? The answer is nothing—if, that is, the suit fits you. If it doesn’t, you are free to admire the cut, but you can’t make any practical use of it. The same is true of the three-fund strategy. It comes in one size, and one size does not fit all investors.

Some critics have pointed to gaps in what the strategy covers, such as international bonds, but the problem, as I see it, isn’t in the general gaps, but in the specific ones. For Americans with particularly high incomes, for example, tax-free municipal bonds are often more attractive than taxable corporate bonds or taxable federal paper. The exact proportion of an investor’s portfolio that should be allocated to tax-free investments varies considerably, depending on the factors that make up the investor’s total tax picture, and as that tax picture changes, prudent investors are well served by remaining vigilant and re-allocating assets as needed.

A slightly different problem is the strategy’s apparent unresponsiveness to an investor’s time horizon. A 32-year-old investor with a good income, investing in a retirement account, should be weighted very heavily in stocks, as they have the highest expected long-term return, and he is essentially unaffected by short-term volatility. At 59-year-old investor who has left the workforce, on the other hand, should be weighted very heavily in bonds. He can’t risk losing money to a market pullback, since he’s going to have to live off the income that money produces. This issue could, in theory, be addressed within the three-fund strategy through active asset allocation, but if the strategy requires active asset management, it raises another question: why not invest in five funds, or nine? What is the supposed advantage of owning only three?

Bobby: I’ll answer your last question first: commissions. Rebalancing between three funds could be done with just three trades, selling one, or two, and then buying in two, or one, rebalancing among nine funds would require a greater number of transactions and anything paid out in commissions or fees is a drag on returns.

Rebalancing is a necessary activity for all investors, whether they’re invested in three vehicles or 300. In addition to the move to less risky assets as one ages, investors should regularly move money between investments to keep their asset balances in line with their target allocations. This can be a difficult task as it effectively requires moving money from the best-performing assets to the underperforming ones. It may seem counterintuitive, but is, in fact, the very definition of buying low and selling high.

As to the issue of asset allocation as an investor ages, this strategy could be used for that, although the 40-20-40 distribution would have to be adjusted. I agree with you that a young investor should be much more heavily weighted in stocks, but I would suggest that the 56-year-old may not want to move as far into fixed-income as you think. Certainly the money that investor needs in the near term should be put somewhere safe, but why should the money he won’t need for 30 years be invested any differently than that of a 30 year old who wants to retire at 60? (This is clearly an entirely different discussion.)

Your point about a tax-free bond fund is also a valid one. I don’t think anyone but the most ardent of Bogleheads would object to an investment in a municipal or other tax-free bond fund in place of a corporate or other bond fund.  There are a variety of bond funds that hold municipal bonds. Some of those funds invest in bonds that all expire at the same date, meaning you would have to purchase a new fund, and others are ongoing funds that will roll maturing bonds into new positions.

On the broader topic of a three-fund portfolio, obviously there’s no three-fund portfolio that will be right for everyone, but with some flexibility about the strategies used by the underlying funds and some discretion about asset allocation, is there any reason an investor NEEDS more than three funds? Wouldn’t picking the right three funds for you and rebalancing periodically be much easier than trying to track a vast collection of investments without sacrificing much in performance?

Julian: In most cases, investors will sacrifice little by owning three funds and periodically rebalancing. There are also plenty of investors for whom this strategy will mean steady returns instead of market losses. But why stop there? Why not choose a single fund that invests in all three classes of investments? Take the Madison Diversified Income A fund (NASDAQ: MBLAX), for example, which invests in domestic bonds, common stocks, real estate securities, foreign market bonds and stocks, and money market instruments. Or for those who wish reduce their tax burden, the Vanguard Tax Managed Balanced fund (VTMFX), which invests equally in stocks and municipal bonds. Why not own both, for that matter? All of this is, I suppose, is merely pointing out that accepting the premise underlying the three-fund strategy doesn’t really change much—in fact, it raises as many questions as it answers.

I also think it makes perfect sense for some investors to reject the premise entirely and direct their investments personally, choosing not only what class of assets to invest in, but the sectors, and even the individual stocks, that are most promising. An investor who is willing and able to do a greater than average amount of research, and who possesses a greater than average degree of discernment, should not necessarily accept average market returns. The market is not a casino, where something like pure randomness exists, and the laws of probability ensure that things are certain to average out in the long run. No such law consigns the exceptional investor to average returns.

Bobby: A single-fund solution may be perfectly suitable for some investors; however those investors will either need to select a target-date fund that adjusts their asset allocations as they get closer to retirement.

As to the investors who want to do their homework and pick their own individual investments. I’d suggest they consider something similar to the three-fund approach with a large portion of their assets and then pick and choose where to invest the rest.

The performance of individual investors is notoriously bad. There have been a variety of studies and other reports about how  and why individual investors underperform broad indices.

Julian: It is true that with three funds, investors can spread their dollars broadly enough as to cover almost everything the market has to offer, but this realization is a starting point, and not, in itself, an overwhelming benefit. It is almost certainly helpful for investors to know about the strategy, which is a reminder that focusing on domestic stocks alone is probably too narrow a focus. Still, all investors must keep in mind that their investments need to be tailored to fit their specific circumstances, and while active trading will certainly produce at least as many losers as it does winners, investors should still keep in mind that if they have the foresight to be in the right place at the right time, doing so will be much more advantageous than being everywhere at all times.

Bobby Raines

Bobby Raines

Bobby Raines is the Managing Editor of the Market Intelligence Center. He has degrees in Mass Communications and History from Emory & Henry College. Bobby worked at a mid-sized daily newspaper before making a switch to covering the financial industry full time in the years leading up to the financial crisis. He has been a member of the Fresh Brewed Media team since 2011 and has served as a writer and analyst. You can write to him at braines@marketintelligencecenter.com or follow him on Twitter: @BRatMICenter.

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