2 Fund and 3 Fund portfolios. Set it and forget it investing.
Simplicity in your investment strategy has many advantages. It’s true that value investing, the Buffet way, is an effective strategy, not everyone has the time to do the required research and manage their investments at the level of Warren Buffet. The nice thing about the 2 fund, or 3 fund portfolio is that it leverages the index investing mindset, which even Warren Buffet suggests is a good strategy.
The basics:
Before we get into the specifics of 2 fund and 3 fund portfolios, let’s set the groundwork.
- Two fund portfolio:
- A 2-fund portfolio consists of two core asset classes, stocks and bonds.
- The allocation between these two funds is based on an investor’s risk tolerance, time horizon, and financial goals.
- Stocks provide growth potential, while bonds offer stability and income.
- Three fund portfolio:
- A 3-fund portfolio expands on the 2-fund concept by adding a third fund, namely international stocks.
- The three funds will be a domestic index stock fund, an international index stock fund, and a bond index fund.
- This approach expands the two-fund concept to include global markets.
“Simplicity is the ultimate sophistication “ – Leonardo da Vinci
Why simple is important? The idea behind the 2 and 3 fund portfolios, as da Vinci said (no, he wasn’t giving investment advice, but the idea is sound), simplicity is not just elegant, it’s effective. Research, including a study by Bogleheads founder Taylor Larimore, supports the idea that keeping investment strategies straight forwards often outperforms more complex approaches. Making your investment strategy complicated with numerous funds can lead to higher fees, higher risk, and possibly poorer performance.
The role of stocks: equities, or stocks, represent ownership in a company. Historically, stocks delivered superior long-term returns, making them an essential part of a growth-oriented portfolio.
The stability of bonds: bonds, in contrast, provide more stability (though there are no guarantees). In times of market volatility, the conservative nature of bonds can buffer the volatile behavior of your portfolio. For those who are risk adverse, or people who are getting closer to retirement, this stability can be important.
Strategic asset allocation: The key to success with a 2-fund portfolio is in the asset allocation. A common rule of thumb is to subtract your age from 100 to determine the percentage of your portfolio allocated to stocks, with the remainder in bonds. This balance allows you to benefit from growth while reducing overall volatility. This is only a rule of thumb and a starting place. If you are more interested in growth and can tolerate market fluctuations, then you may choose more stock. Likewise, if you can’t sleep at night when the market is bouncing around, you may choose a larger percentage of bonds.
Adding some international exposure: Index investing in 2 fund and 3 fund portfolios.
As we discuss the simplicity and effectiveness of the 2 or 3 fund portfolios, it’s good to understand a critical element of the concept, index investing. Index funds play an important role in these strategies, offering low cost, diversified approaches to building wealth. Also, for those who are focused on a domestic strategy, it can still offer some small international exposure.
The Essence of Index Investing:
“Don’t look for the needle in the haystack. Just buy the haystack!” – John C. Bogle
Index investing, championed by the late Jack Bogle, the founder of Vanguard, revolves around a simple yet powerful idea: instead of attempting to outsmart the market, invest in the entire market. Index funds track a specific market index, such as the S&P 500 for domestic stocks or the MSCI World Index for global stocks. By doing so, they provide broad market exposure and aim to replicate the market’s overall performance. While domestic index funds are primarily designed to track the performance of their respective home markets, they often include multinational corporations with global operations. This inherent international exposure is a noteworthy aspect for investors in 2 Fund Portfolios with a focus on simplicity and the U.S. market.
The International Touch in Domestic Index Funds:
- Multinational Corporations: Many large companies listed in domestic indexes operate globally. For instance, the S&P 500 includes multinational giants like Apple, Microsoft, and Coca-Cola, which generate a significant portion of their revenue internationally.
- Global Revenue Impact: The revenue streams of these multinational corporations are influenced by international markets. Therefore, when you invest in a domestic index fund, you indirectly gain exposure to the global economic landscape.
- Diversification Benefits: While the primary objective of a domestic index fund is to mirror the performance of the domestic market, the inclusion of companies with international operations can enhance diversification. This can be particularly appealing for investors seeking a balanced yet straightforward approach to portfolio construction.
Index Funds in a 2 Fund Portfolio:
- Domestic Stock Index Fund:
- A cornerstone of many 2 Fund Portfolios is a domestic stock index fund, such as the Vanguard Total Stock Market Index Fund (VTSMX).
- This fund captures the performance of the entire U.S. stock market, including large, mid-sized, small-cap stocks, offering investors a diversified slice of domestic equities.
- Bond Index Fund:
- Complementing the domestic stock component is a bond index fund, like the Vanguard Total Bond Market Index Fund (VBMFX).
- This fund provides exposure to a broad range of U.S. bonds, offering stability and income to balance the equity portion of the portfolio.
Index Investing in a 3 Fund Portfolio:
Expanding our perspective to the 3 Fund Portfolio, international exposure becomes even more explicit.
- Domestic Stock Index Fund:
- The domestic component of the 3 Fund Portfolio remains anchored by a domestic stock index fund, such as the Vanguard Total Stock Market Index Fund.
- International Stock Index Fund:
- Introducing the global element, investors can include an international stock index fund, like the Vanguard Total International Stock Index Fund (VGTSX).
- This fund broadens exposure to international markets, encompassing developed and emerging economies.
- Bond Index Fund:
- The bond index fund continues to play a vital role, offering stability and income.
The Wisdom of Diversification:
“Don’t put all your eggs in one basket.” – Proverb
Diversification is a timeless principle of investing, and the inclusion of international exposure, even within a predominantly domestic portfolio, aligns with this wisdom. The inherent risks and opportunities across global markets can contribute to a more resilient and robust investment strategy.
As we wrap up our exploration of 2 and 3 Fund Portfolios on The Healthy Wealthy Sage, let’s reflect on the synergy between simplicity, index investing, and international exposure. Index funds, by mirroring the broader market, provide a foundation for building wealth without the complexities of individual stock selection.
For those leaning towards a domestic-centric strategy, it’s reassuring to recognize that domestic index funds organically offer a taste of international markets through multinational corporations. However, for those seeking a more deliberate international component, the 3 Fund Portfolio introduces a dedicated international stock index fund.
Remember, the essence of a sage approach to wealth building lies in understanding your goals, managing risks wisely, and embracing a strategy that aligns with your financial journey. Whether you choose the simplicity of a 2 Fund Portfolio or the global diversification of a 3 Fund Portfolio, let the principles of index investing and international exposure be your allies in the pursuit of financial well-being.