Your Guide to the Bogleheads 3 Fund Portfolio

Whether you’re new to investing or want to expand your knowledge base, you’re likely to be interested in different investing strategies. One term you may have come across is the Bogleheads 3 Fund Portfolio. In this article, we’ll explore this type of portfolio to help you decide if this strategy could work for you.

Who are the Bogleheads?

The term “Bogleheads” is used to honor John Bogle, the Vanguard founder. The Vanguard Group is an asset management firm and the world’s biggest provider of mutual funds and the 2nd biggest exchange-traded funds provider.

Bogleheads are investment enthusiasts who are active on the Bogleheads forum, where financial news, theory and techniques are discussed. The forum has over 120,000 members and almost 2,000 posts are added each day, helping less experienced investors to develop their portfolios and the more experienced to discuss merits of different strategies. 

While Bogleheads is a forum community, there are actually a number of investment books and affiliated sites that discuss Bogleheads investing. 

What is the Bogleheads 3 Fund Portfolio?

There are several key principles ascribed to the Bogleheads investing approach. These include: 

• Develop workable plans

• Invest often and early

• Never bear too little or too much risk

• Diversify

• Avoid trying to time the market

• Keep costs low

• Use index funds when possible

• Minimize taxes

• Invest simply

• Stay the course.

The Bogleheads 3 Fund Portfolio is designed to adhere to all of the above principles. It is a simple portfolio that comprises three broad asset classes: a U.S. total market index fund, an international total market index fund and a U.S. bond total market index fund. 

This portfolio operates on the idea that diversification within your portfolio will reduce volatility, maximize risk-adjusted return and provide protection against any “black swan” events, or events that are unexpected and have the potential for severe consequences.

For example, while the 2020 Coronavirus pandemic was a severe economic event, pandemics are not unique situations and they do occur. For this reason, COVID was not a black swan event. However, the September 11 terror attacks were a black swan, creating a ripple of uncertainty throughout the world. 

It is important to note that the Bogleheads 3 Fund does not use a one size fits all asset allocation prescription. You are encouraged to choose your own asset allocation according to your specific risk tolerance and time horizon. However, Jack Bogle suggested a ratio of 60/20/20 allocation, with 60% into U.S. stocks, 20% in international stocks and the final 20% into U.S. bonds. 

The Benefits of a 3 Fund Portfolio

According to leading Boglehead, Taylor Larimore, co-author of several Boglehead books, there are 20 benefits of a three fund portfolio. These include:

• No advisory risk: Advisor risks, such as conflicts of interest or incompetence will invariably lower returns through greater fees and/or underperformance. 

• No fund manager risk: Future performance can be impacted by managers leaving an active fund. However, index funds don’t pick individual stocks.

• No individual stock risk: Over the long term, picking individual stocks is notorious for underperformance. 

• No asset bloat: When new money enters a managed fund, it impacts prices and can lower the expected returns. Total market index funds are able to easily spread the new money across thousands of assets. 

• No index front running: This means that traders can preemptively buy or sell securities before they are excluded or included in the index. Working within the total market eliminates exposure to this impact. 

• No overlap: There is zero overlap in a three fund portfolio, so diversification is maximized and you can avoid concentration. 

• No sector risks: Sector picking can be a source of uncompensated risk, acting as a lighter version of stock picking. With a total market index fund, you’ll already have exposure to every sector.

• Low tracking error: Tracking error is the difference between the true value of the fund and the underlying index that it is attempting to track. The funds used in Bogleheads portfolio strategy have the lowest tracking error rates across the investment niche.

• No style drift: This refers to divergence from the stated investment focus. For example, if you have a mid cap value fund that is focused on a narrow market subsection, there is a great risk of style drift. When buying the total market, there is no concern about style drift. 

• Above average returns: This is ensured by the concept that most active investors lag the market after trading costs, fees and taxes. The market return is the average of all the investors in the market. 

• Simplified transactions: Since there are only three funds, the contributions and withdrawals are simplified. It means less time and effort is needed to perform transactions across your assets. 

• Greater consistency: With actively managed funds and narrower index funds, style, risk profile, selection methodology and even the manager can change more often than you may realize. When buying the total market, you don’t have to worry about these issues. 

• Low turnover: The term turnover is used to describe how much a fund does to periodically replace its securities. When there is a higher turnover, it means more costs due to spreads, admin costs, taxes and commissions. Total market funds have the lowest turnovers. 

• Lower costs: This follows on from the previous point, but total market index funds typically have the lowest fees and charges. 

• Maximized diversification: The three fund portfolio provides diversification globally across different asset classes to lower investor risk. 

• Efficiency of the portfolio: Total market index funds tend to offer the highest returns for given levels of risk. Since efficiency is determined by the risk/return ratio, you can be assured of great portfolio efficiency. 

• Ease of rebalancing: Periodically, you need to bring a portfolio back to the target asset allocation as there is a shift over time. This is commonly known as rebalancing. Having fewer funds means that rebalancing only needs to occur once a year or even every couple of years. 

• Low maintenance: Portfolio maintenance typically increases in direct proportion to the number of funds. By keeping things simple using three funds, it saves time and effort to maintain your portfolio. 

• Tax efficiency: Index funds tend to be some of the most tax-efficient investment products, due to the lower turnover and fewer taxable capital gains distributions.

• Simplicity: This should not be under-appreciated, but by simplifying your investments, you’ll have more time to manage other priorities in your life. It can also cut down on the psychological stress involved in maintaining your portfolio and the inevitable tracking errors that occur when you’re overextended. 

How to Choose Assets

Even if you plan on using a single fund, you need to decide the percentage you want to invest in stocks, choosing a fund that matches. Some of the assets you could explore include:

U.S. Stocks: 

As we discussed above, you’re aiming for a 60% U.S. stock position. There are several choices for this including the total U.S. stock market, which is advisable. However, you could also consider the S&P 500 Index, the Russell 1000 index and others. 

You are aiming to broadly diversify across U.S. stocks, so it is a good idea to consider the total U.S. stock market fund, which will provide some exposure to both small and mid cap stocks, which have historically outperformed large cap stocks. 

International Stocks:

Likewise, for your 20% allocation into international stocks, it is a good idea to look for a total international stock market fund. This will allow you to access offerings across the global stock market. Examples of these include Vanguard’s VXUS and the Fidelity FTIHX. 

Bonds:

The most popular and obvious choice for the bond allocation of a three fund portfolio is a total U.S. bond market fund. However, you will need to consider whether you want to lean more towards treasury bonds rather than weighing your portfolio on corporate bonds. 

You also need to consider volatility. Long-term bonds are too susceptible to risk for the interest rate for the older investor, while short-term bonds are likely to be too conservative for the younger investor. Therefore, a good compromise could be intermediate-term treasury bonds. These should match the average total treasury bond market approximately. 

International Bonds:

Another interesting point to note is the lack of inclusion for international bonds and there are a number of reasons for this. Until recently, international bonds were not included in diversified portfolios or target date funds. This is likely to be due to these products being cost-prohibitive and a large amount of skepticism about the products. 

Generally speaking, international bonds may only offer small diversification benefits due to a low correlation between U.S. stocks and U.S. bonds. The potential diversification benefits are less convincing when your portfolio is not bond heavy. 

So, if you’re sticking to the 60/20/20 Bogleheads 3 fund portfolio approach, it is best to give international bonds a miss. 

Summary

The Bogleheads 3 fund portfolio is described as a lazy investing method, simplifying the process to appeal to investors who want to minimize management and lower risk. Of course, while there is a massive community that is dedicated to the Bogleheads approach, there are other investing experts who disagree with this approach. 

So, as with any investment decision or strategy, it is important to assess the benefits and risks for yourself. You will need to evaluate your investing goals, risk aversion and approach to determine if the three fund portfolio could be a good fit for you.