Who Is the 3-Fund Portfolio Right For?

Key Takeaways

• A basic three-fund portfolio includes a US equity index fund, an international-equity index fund, and a total bond market index fund. It can be an exchange-traded fund portfolio or a traditional index portfolio.
• Simplicity is a major selling point for three-fund portfolios. They are ultralow maintenance and also low-cost.
• A three-fund portfolio might not always be a perfect fit, especially for investors’ taxable accounts.
• The three-fund portfolio is still missing some key ingredients for retirees, one of which is a dedicated cash allocation.

Margaret Giles: Hi, I’m Margaret Giles from Morningstar. Index enthusiasts often talk about a three-fund portfolio as a simple way to build a diversified investment portfolio. Joining me to discuss the benefits of such a portfolio, as well as what it’s missing, is Christine Benz. She’s the director of personal finance and retirement planning for Morningstar. Christine, thanks for being here.

Christine Benz: Margaret, it’s great to see you.

What Is a Typical Three-Fund Portfolio?

Giles: Before we get into the three-fund portfolio, what are the three key building blocks of a portfolio?

Giles: A basic three-fund portfolio includes a US equity index fund, an international-equity index fund, and a total bond market index fund. It can be an exchange-traded fund portfolio or a traditional index portfolio. It doesn’t really matter.

Benefits of a Three-Fund Portfolio

Giles: OK. So, simplicity is obviously the major selling point there, but what else does the three-fund portfolio have going for it?

Benz: Well, one is that it’s ultralow maintenance, so you might need to change around the allocations a little bit. As you get closer to retirement and enter retirement, you’d probably want to emphasize that total bond market index a little bit more, but generally, it’s pretty hands-off. You’re not having to worry about fund manager comings and goings, or anything going on at the operational level that is going to change the exposure that you receive. Then, low costs are the other big selling point with a three-fund portfolio. Most broad market index funds are very, very cheap. It’s not at all difficult to assemble a three-fund portfolio and pay less than 5 basis points for it, which is a really, really nice long-term tailwind for this kind of portfolio.

Why the Three-Fund Portfolio Is Not Ideal for Investors With Taxable Accounts

Giles: Absolutely. You note that the three-fund portfolio might not always be a perfect fit, though, especially for investors’ taxable accounts. Can you explain that a little bit?

Benz: Right. So, a total bond market index is part of this three-fund portfolio. If you own a taxable-bond fund, whether an index fund or a nonindex fund, you’re going to pay ordinary income tax on any income distributions that you receive. So, it’ll tend not to be a great fit for taxable accounts. Tax-sheltered accounts, it doesn’t really matter. You do not pay that full freight on your ordinary income distributions, but if you’re owning it in a taxable account, you may want to think about using a broad market municipal-bond fund instead, where you can avoid federal income taxes on those income distributions. If you buy one specific to your state where you live, you may be able to avoid state income tax as well.

Why Young Accumulators Can Have an Even Simpler Portfolio

Giles: OK. You also think the three-fund portfolio might not be a great fit for young accumulators in search of simplicity. Why is that?

Benz: Well, young accumulators really need to keep their eyes on two main things. One is that they need to have an emergency fund to cover unexpected expenses. So they need cash, but then they also need growth. So, they probably need bonds a bit less. In fact, I think that for people in their 20s and 30s, they can reasonably have an all-equity portfolio paired with some cash holdings. I think for people at that life stage, they could reasonably have like a total global index fund or a total world stock index fund, as well as some cash as emergency reserves, and call it a day. They probably don’t need three individual funds.

Giles: So, they can go even simpler then.

Benz: I think so.

What Is Missing From the Three-Fund Portfolio for Retirees

Giles: To wrap up here, let’s talk about retirees. You think the three-fund portfolio is still missing some key ingredients for them. Why is that?

Benz: Definitely. I’m an enthusiast for the Bucket approach. So, a three-fund portfolio would not include a dedicated cash allocation. Certainly, people in retirement, I would think, should run with maybe a year to two years’ worth of liquid reserves and true cash assets. Then the total bond market index is missing a few key ingredients. One is that it doesn’t include inflation-protected securities. That’s one reason why in all of my model portfolios for tax-sheltered accounts, I do carve out a specific allocation to a TIPS fund.

The other drawback with a total bond market index is that even though it does include short-term bonds, you can’t tell your index fund provider that in a given year like 2022, where longer-term bonds got crunched, you can’t say, “Well, I need a withdrawal, but I just want my short-term bonds.” So, I think investors, when they’re thinking about building out their retirement portfolios, should make sure that they have exposure to TIPS, Treasury Inflation-Protected Securities, as well as dedicated exposure to short-term bonds, even if they want to have the majority of their portfolio in a very simple three-fund portfolio.

Giles: Well, Christine, thanks for the context and who this type of portfolio works for and maybe who doesn’t.

Benz: Thank you so much, Margaret.

Giles: I’m Margaret Giles with Morningstar. Thanks for watching.

Watch Can Your Investment Portfolio Be Too Diversified? for more from Christine Benz.