How to use a 3-fund portfolio in your 401(k)
When it comes to choosing investments for your 401(k), the number of options available can be overwhelming. There are, however, a number of relatively simple investment strategies you can use to get the most out of your 401(k).
One strategy is to invest in a target date fund, which will automatically optimize your portfolio for retirement on a certain date. Another slightly more complicated approach is to build a 3-fund portfolio.
With the 3-fund approach, you’ll have to do a bit more research to find suitable funds, but you’ll have more control than with a simple target date fund. In this article, we’ll explain what a 3-fund portfolio is, how it works, and some of its key benefits.
- A 3-fund portfolio aims to diversify your portfolio across three asset classes: domestic equities, international equities and domestic bonds.
- You can use a 3-fund approach in most 401(k) accounts.
- Investors choose the allocation of funds that suits their objectives.
- A 3-fund approach offers diversification and offers more control than a single-fund approach like a target date fund.
What is a 3-fund portfolio?
The idea of a 3-fund portfolio prioritizes diversification, a fundamental concept of investing.
However, this approach also offers simplicity for average investors managing their 401(k). A portfolio of 3 funds focuses on three fundamental asset classes: domestic (US) equities, international equities and domestic bonds. Major brokers offer mutual funds that provide exposure to each type of asset.
Investors can then determine the best allocation of funds concentrated in each asset class according to their investment horizon. For example, you may have a portfolio that is 90% stocks and 10% bonds, or vice versa.
US stocks tend to offer the potential for higher long-term returns, but they also carry more risk, so younger investors may want to allocate more funds to them.
International equities may also offer the potential for higher gains in emerging markets and diversification from US equities. Finally, bonds may not offer the potential for aggressive gains, but they do offer less risk. Investors nearing retirement may want to allocate more money to a bond fund.
Advantages and disadvantages of a 3-fund portfolio
When it comes to managing the investments in your 401(k), you may have to compromise between simplicity and control. Although a target date fund requires less effort to make investment decisions, you will lose some freedom in your investment choices. On the other hand, you can carefully research and manage every aspect of your portfolio, choosing individual stocks that you think will increase in value, but are likely to have increased risk.
A 3-fund portfolio offers a midpoint between these approaches. It offers you most of the diversification of a target date fund, while allowing you to tailor your investments to your needs.
An example of this is your portfolio’s asset allocation. If you’re in your 20s or 30s and put all your 401(k) money in a target date fund tied to your expected retirement age, you can start with 90% of your assets invested in stocks and 10 % invested in bonds. By the time you reach 50, the same target maturity fund may have 40% or more invested in bonds, which can reduce your returns just before you reach retirement. By managing your own portfolio, you can manage your own risk.
As with any investment approach, the 3-fund portfolio also has drawbacks. By choosing just three asset classes, you are missing out on broader diversification with other types of assets like real estate assets or gold. Another downside is that you’ll be responsible for some of the management, like making sure you have the right mix of bonds and stocks. Whereas target date funds have automated rebalancing.
Due to their simplicity, low fees, and diversification, 3-fund portfolios are popular among the “Boglehead” community. They are investors who follow the principles defended by the founder of Vanguard, John Bogle.
Build a 3-fund portfolio
If you decide to use a 3-fund approach for your 401(k) portfolio, you have two main decisions to make. First, you need to determine your asset allocation ratios. Next, you’ll need to choose the exact funds for three basic asset classes.
Your asset allocation is how you divide your asset types to manage the risk and return potential that suits your goals. With the 3-fund approach, you allocate a certain percentage of your portfolio to one of three types of assets: US stocks, international stocks and bonds.
Consider your risk tolerance and investment time horizon when choosing your allocation. Young investors generally have a higher risk tolerance because they have a longer investment horizon, so they can know the ups and downs of the market. Thus, younger investors may want to invest more in aggressive assets like stocks.
Older investors, including those approaching or in retirement, tend to prioritize capital preservation. They may therefore want a higher proportion of low-risk assets, such as bonds, to protect the funds they need for living expenses.
Choose your funds
The final step in building a 3-fund portfolio is choosing specific funds. As a general rule, you should look for low-cost, well-diversified funds. All major brokers have funds that represent each of the basic asset types, so you can build a 3-fund portfolio through a single broker or spread your investments across multiple brokers.
For example, you can have a portfolio with these three Vanguard mutual funds:
- Vanguard Total Stock Market Index Fund (VTSAX)
- Vanguard Total International Stock Index Fund (VTIAX)
- Vanguard Total Bond Market Fund (VBTLX)
You can also use exchange-traded funds (ETFs) to invest in asset types. A similar portfolio would include:
- Vanguard Total Stock Market ETF (VTI)
- Vanguard Total International Stock ETF (VXUS)
- Vanguard Total Bond Market ETF (BND)
Shop around to find the funds that suit your needs and consider consulting a financial advisor for advice on aligning your portfolio with your investment goals.
What is a 3-fund portfolio?
A 3-fund portfolio is a way to balance simplicity and diversification. A 3-fund portfolio will normally be divided into three asset classes: domestic (US) stocks, international stocks and domestic bonds.
Can I create a 3-fund portfolio in my 401(k)?
Most 401(k) plans will allow you to add a range of mutual funds, and so you can use a 3-fund portfolio approach. However, some employers have more limited investment options for their 401(k) plans. In this case, you may not be able to build a 3-fund portfolio through your 401(k).
What are the advantages of a 3-fund portfolio?
A 3-fund portfolio offers some of the simplicity of a target date fund, while offering a bit more control over your asset allocation. You can tailor your asset allocations to your investment goals and create diversity within your portfolio.
A 3-fund portfolio is a portfolio management approach that focuses on using three funds to invest in three types of assets, typically US stocks, international stocks and bonds. This strategy is popular among the Boglehead community, which follows the investment principles championed by Vanguard founder John Bogle.
You can use a 3-fund approach in most 401(k) accounts, depending on whether your employer offers funds to represent each type of asset. You will need to decide which three funds to use and how they will be distributed in your portfolio.