Selecting an investment strategy is one of the most important aspects of investing. This includes being an active or passive investor, making decisions about the types of investments you will use, and understanding your asset allocation. Each of these elements requires careful thought and execution, and there are many ways to do it. The Three-Fund Portfolio is a very simple way to implement many elements of an investment plan into a single strategy.
What is the Three-Fund Portfolio?
The Three-Fund Portfolio is a complete portfolio consisting only of three mutual funds or exchange-traded funds (ETFs). By using only three funds, you can simplify not only the execution but also the ongoing management of your investments. This is because with fewer funds, you have less to track and fewer transactions to make when adding money to your portfolio or rebalancing compared to a portfolio that contains a larger number of investments.
Measuring the Performance of the Three-Fund Portfolio
Like any investment strategy, you should be able to track the performance of the Three-Fund Portfolio. To track and measure the historical performance of the Three-Fund Portfolio, you first need to select the three funds you wish to include in your portfolio and research the historical returns for each fund. Next, you will need to determine the weight of each fund within the portfolio. For example, let’s assume you created a Three-Fund Portfolio with the following exchange-traded funds: VTI: Vanguard Total Stock Market ETF (Total U.S. Stock Market), VEU: Vanguard FTSE All-World ex-US ETF (International Stocks), BND: Vanguard Total Bond Market ETF (Bond Fund).
For simplicity, let’s assume you allocate the portfolio equally among the three funds: 33% in each of the stock funds and 34% in the bond fund. We can calculate the overall market return for this portfolio for the year 2020 as follows by first looking at the weighted average for each fund, which is the annual return multiplied by the allocation:
VTI VEU BND
2020 Return 21.05% 11.06% 7.69%
Allocation 33% 33% 34%
Weighted Average 6.95% 3.65% 2.61%
The total market return for 2020 will be the sum of the weighted averages for each fund: 13.21%. You can use this to determine if the annual return aligns with what you are looking for in your investment. Although past performance does not guarantee future returns, it may provide some insights into how the fund has performed over time.
Measuring the Performance of the Three-Fund Portfolio Over 5 and 10 Years
Looking back five or ten years instead of just one year can give you a better understanding of how the Three-Fund Portfolio has performed. Diversifying your allocation can also enhance your research. In addition to the moderate allocation (33%, 33%, 34%) in the previous example, you might choose a conservative approach where you allocate 10% to each stock fund and 80% to the bond fund. Or you could experiment with a more aggressive approach by allocating 40% to each stock fund and the remaining 20% to the bond fund.
Let’s take a look at how each of these three portfolios has performed over the past five and ten years. Each year in the table below uses the weighted average.
Example of Portfolio Returns
Conservative Portfolio (10%, 10%, 80%) Moderate Portfolio (33%, 33%, 34%) Aggressive Portfolio (40%, 40%, 20%)
2020 14.38% 9.36% 13.21%
2019 12.26% 20.16% 22.56%
2018 -2.00% -6.43% -7.77%
2017 7.69% 17.22% 20.12%
2016 7.58% 3.80% 6.70%
2015 -0.05% -1.28% -1.66%
2014 5.50% 4.64% 4.38%
2013 3.09% 15.04% 18.68%
2012 6.71% 12.96% 14.87%
2011
4.99% -1.63% -3.64%
The table below shows the average return rate for each of these portfolios over five and ten years. As you can see, although the portfolios were built from the same ETFs, the choice of specific asset allocation made a significant difference in each portfolio’s return.
Average Return of the Portfolio
Conservative Portfolio (10%, 10%, 80%) Moderate Portfolio (33%, 33%, 34%) Aggressive Portfolio (40%, 40%, 20%)
Average Over 10 Years 6.02% 7.38% 8.75%
Average Over 5 Years 7.98% 8.82% 10.96%
Note: If you invested in your three-fund portfolio, your statement should also reflect your performance.
Building Your Three-Fund Portfolio
To build your three-fund portfolio, start by defining your goals, risk tolerance, and time frame. This is the first step in any investment strategy to determine your asset allocation and ensure that your investment plan is suitable for you.
Once you decide on your asset allocation strategy, you need to choose the individual mutual funds or ETFs that you want to build your portfolio with. Remember, a three-fund portfolio typically relies on low-cost index funds due to their low fees and the broad diversification they offer. The execution is a matter of buying the funds you choose in the asset allocation proportions you selected.
Note: To maintain your asset allocation, you will need to rebalance your portfolio periodically, either at regular intervals or when you drift too far from the specified allocation.
Should You Have a Three-Fund Portfolio?
There is no one-size-fits-all investment strategy that applies to every situation. A simple three-fund portfolio may be suitable for you if you value simplicity, low costs, and prefer to manage things yourself, but you can also experiment with a portfolio that contains four funds or even a portfolio that contains five funds – it all depends on your choice. Adjust your asset allocation strategy to match your risk tolerance as well. Whether you are an aggressive or conservative investor, you will ultimately find the optimal point for you.
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Sources:
Vanguard. “Vanguard Total Bond Market ETF.”
Vanguard. “Vanguard FTSE All-World ex-US ETF.”
Vanguard. “Vanguard Total Stock Market ETF.”
Source: https://www.thebalancemoney.com/comparing-three-fund-portfolios-over-time-5115820
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