When it comes to choosing investments for your 401(k), the sheer number of options available can be overwhelming. However, there are 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 automatically optimizes your portfolio for retirement on a specific date. Constructing a 3-fund portfolio is a slightly more complicated approach.
With the 3-fund approach, you’ll need to do a little more research to find suitable funds, but you’ll have more control than you would with a target-date fund. In this article, we explain what a 3-fund portfolio is, how it works and some of its key benefits.
- 3-Fund Portfolio aims to diversify your portfolio across three asset classes: domestic stocks, international stocks and domestic bonds.
- You can use the 3-fund method in most 401(k) accounts.
- Investors choose an allocation of funds that suits their goals.
- A 3-fund approach provides diversification and more control than a single-fund approach like a target-date fund.
3-What is a fund portfolio?
3-The idea of a fund portfolio prioritizes the fundamental concept of investing, diversification.
However, this approach provides the average investor with simplicity in managing their 401(k). A 3-fund portfolio focuses on three basic asset classes: domestic (US) stocks, international stocks, and domestic bonds. Major brokers offer mutual funds that give exposure to almost every type of asset.
Investors can decide on the best allocation of funds focused on each asset class based on their investment horizon. For example, you might have a portfolio made up of 90% stocks and 10% bonds, or vice versa.
US stocks offer high return potential over the long term, but they also carry high risk, so younger investors may want to allocate more money to them.
International stocks can also offer higher returns in emerging markets and the potential for diversification away from US stocks. Finally, bonds may not offer the potential for aggressive returns, but they do offer less risk. Investors approaching retirement may want to allocate more money to a bond fund.
3-Pros and cons of fund portfolio
When it comes to managing the investments in your 401(k), you may have to compromise between simplicity and control. While a target-date fund requires less effort with making investment decisions, you lose some freedom in your investment choices. On the other hand, you can carefully research and manage every aspect of your portfolio, picking individual stocks that you think will increase in value, but you can increase risk.
A 3-fund portfolio offers a mid-point between these approaches. This gives you a greater diversity of target-date funds, while also allowing you to tailor your investments to suit your needs.
An example of this is the asset allocation in your portfolio. If you’re in your 20s or 30s and keep all of your 401(k) money in a target date fund tied to your expected retirement age, you might start with 90% of your assets invested in stocks and 10% in bonds. By the time you reach your 50s, the same target-date fund may have 40% or more invested in bonds, which could reduce your returns before you reach retirement. By managing your own portfolio, you can manage your own risk.
As with any approach to investing, the 3-fund portfolio has its drawbacks. By choosing only three asset classes, you miss out on wide diversification with other asset types like real estate assets or gold. Another drawback is that you are responsible for some maintenance, such as making sure you have the right mix of bonds and stocks. Target-date funds have automatic re-balancing.
Because of their simplicity, low fees and diversification, 3-fund portfolios are popular among the “boglehead” community. These are investors who follow the principles established by Vanguard founder John Bogle.
3-Building a fund portfolio
If you decide to use the 3-fund approach for your 401(k) portfolio, you’ll need to make two important decisions. First, you need to determine your asset allocation ratios. Then, you need to choose the exact funds for the three basic asset classes.
Distribution of property
Your asset allocation is how you divide your asset types to manage risk and return potential that matches 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 your investment horizon when you choose your allocation mix. Younger investors generally have a higher risk tolerance because they have a longer investment horizon, so they can ride market fluctuations. Hence, younger investors may want to invest more in aggressive assets like stocks.
Older investors, including those nearing or in retirement, prefer capital preservation. So they may want a higher proportion of low-risk assets, such as bonds, to protect money they need to use for living expenses.
Choosing your funds
3-The final step in building a fund portfolio is deciding on specific funds. In general, you should look for funds that have lower costs and are well diversified. All major brokers have funds representing each underlying asset type, so you can build a 3-fund portfolio with just one broker or spread your investments across multiple brokers.
For example, you might 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 classes. A similar portfolio includes:
- Vanguard Total Stock Market ETF (VTI)
- Vanguard Total International Stock ETF (VXUS)
- Vanguard Total Bond Market ETF (BND)
Consult a financial advisor for guidance on purchasing the right funds for your needs and aligning your portfolio with your investment goals.
3-What is a fund portfolio?
A 3-fund portfolio is a way to balance simplicity with diversification. 3-A fund portfolio is typically divided between three asset classes: domestic (US) stocks, international stocks, and domestic bonds.
Can I build a 3-fund portfolio in my 401(k)?
Most 401(k) plans allow you to include a range of mutual funds, and so you can use the 3-fund portfolio approach. 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).
3-What are the benefits of fund portfolio?
A 3-fund portfolio offers some of the simplicity of a target-date fund, but provides a little more control over your asset allocation. You can adjust your asset allocations to your investment goals and create diversity in your portfolio.
The bottom line
A 3-fund portfolio is an approach to portfolio management that focuses on using three funds to invest in three asset types, typically US stocks, international stocks, and bonds. This strategy is popular among the Boglehead community, who follow the investment principles established by Vanguard founder John Bogle.
You can use the 3-fund method in most 401(k) accounts, depending on whether your employer offers funds to represent each asset type. You need to decide which three funds to use in your portfolio and their allocation.