Bogleheads and the Three Fund Portfolio

The Bogleheads can help you invest wisely

In the Get FI article I mention several resources for investing wisely including the excellent book “The Bogleheads’ Guide to Investing

The Bogleheads are a group whose name honors Jack Bogle. Mr. Bogle has been a champion of the individual investor and a pioneer of index mutual funds. The Bogleheads maintain an investing wiki and a forum for investing advice and discussion.

The Bogleheads wiki

The wiki is a great place to educate yourself if you want to get FI. Where to start? The getting started page. As you start to learn the basics you will eventually come across the “Three Fund Portfolio”:

Investing with the Three Fund Portfolio

You pick three index funds; a total US stock market index fund, a total US bond index fund and a total international stock market index fund. If you are using Vanguard funds the three funds are:

Vanguard Total Stock Market Index Fund (VTSMX)

Vanguard Total International Stock Index Fund (VGTSX)

Vanguard Total Bond Market Fund (VBMFX)

You then pick an asset allocation which is individualized. For example you could decide you want to have your age in the bond fund VBMFX. Then 100 – (your age) will be in the stock funds VTSMX and VGTSX. Next you decide what percentage will be US (VTSMX) and what percentage will be international (VGTSX). There is some disagreement among experts here. My approach is to have 20% in international. So what would this look like for a 30 year old?

Age in bonds would be 30% in the bond fund VBMFX

Then 100% – (30%) is 70% in the stock funds VTSMX and VGTSX

Of the 70% in stock funds 20% (20% of 70% is 14%) of the total is in international (VGTSX)

Of the 70% in stock funds 80% (80% of 70% is 56%) of the total is in US (VTSMX)

So for a 30 year old who uses the age in bonds formula with 20% of stock funds in international:
Three fund portfolio
30% in VBMFX

56% in VTSMX

14% in VGTSX

The Three Fund Portfolio wiki has more info, and if you have any questions you can ask them in the Bogleheads forum. Selling investments in a taxable account to set up a Three Fund Portfolio may incur taxes. So make sure you understand any tax implications.

Low costs matter… a lot

The costs of the Three Fund Portfolio from Vanguard are the ‘Expense Ratio (ER)’. The three funds currently (July 2017) have expense ratios of:

VBMFX: 0.15%

VTSMX: 0.15%

VGTSX: 0.18%

It is important to understand you pay these fees every year regardless of whether the funds increase in value. In the above example the overall ER for the portfolio is 0.1542%. For comparison, an all-in-one fund from Vanguard that has 25% in fixed income and 75% in equities, Vanguard Target Retirement 2030 Fund (VTHRX), has an ER of 0.15%, basically the same. I found an all-in-one fund from a well-known competitor that has an ER of 1.42%. That is more than 9 times as expensive as either the Vanguard Three Fund Portfolio or the VTHRX all-in-one fund. Does it really make a difference between 0.15% and 1.42%? Yes, over a long time span it makes a huge difference. If we estimate returns on a $10,000 investment over 25 years using the default 6.0% yearly return from the Vanguard cost calculator we see that with a 0.15% ER we end up with $94,362.22. At a 1.41% ER (the calculator does not accept 1.42%) the returns are $66,347.98. A difference of $28,014. Since one will likely be contributing constantly over this 25 years, the differences will likely be much higher. Now imagine 25-year-old you walks up to 50-year-old you with a suitcase containing $28,014 cash. Thank you very much for paying attention to costs, 25-year-old you.

So why not just use VTHRX and keep it even simpler?

Actually that is a perfectly good solution and one that might be best when starting out, particularly since the minimum investment for VTHRX is only $1,000. But there are 2 major advantages to the Three Fund Portfolio.

First, once your assets grow you can move from the ‘Investor’ class to the ‘Admiral’ class of the three funds that have lower ERs. The Admiral class funds have higher minimum investments:

Vanguard Admiral Funds

In the Three Fund Portfolio example above the overall ER for the portfolio with Admiral class funds would now drop to 0.0528%. If we plug that into the Vanguard calculator (use 0.06% as we cannot plug in 0.0528%) we see we can save even more, now we would have $96,734.46 after 25 years. So we save another $2,372. Again I’m pretty sure 50-year-old you will thank 25-year-old you for the extra $2,372.

Second, the Three fund portfolio allows you to better organize your portfolio for tax efficiency. You can keep bond funds in tax-advantaged accounts (Roth, Traditional IRA, 401k, 403b) and equities in taxable accounts which allows you to tax harvest losses and also tax harvest gains. This is complex and we won’t delve into it here. If you are just starting out it is fine to go with a low cost, all in one fund like VTHRX and worry about improving tax efficiency later.

Will a more expensive, actively managed fund outperform the Three Fund Portfolio?

The short answer is it might, but probably not. The Three Fund Portfolio is comprised of index funds that do not attempt to beat the market, only capture its returns. Rick Ferri and Alex Benke compared a Three Fund Portfolio to actively managed funds and found that the Three Fund Portfolio outperformed 82.9% of active funds over a 16 year period. See their white paper.

But I saw an advertisement for a fund that consistently beats the S&P500

See survivorship bias.

The investment policy statement (IPS)

An IPS, described here, is basically a set of rules you set for yourself to help you ignore market volatility and capture market returns over a long investment horizon. If you don’t have an IPS, maybe a month after setting up the Three Fund Portfolio the stock market gets hot. You decide you want to increase your stock holdings and change to an age – 10% in bonds formula to increase equity exposure. You sell some of your VBMFX and buy VTSMX and VGTSX. Then 2 months later there is a market correction and stocks go way down. Now having seen your portfolio drop in value you decide it wasn’t such a great idea to have age -10% in bonds, and you want to go back to the more conservative age in bonds formula. So you sell VTSMX and VGTSX and buy VBMFX. Congratulations, you have now just bought high and sold low. This is why many people never capture the returns of the market, they let emotions control their investment decisions. The IPS is a mechanism to keep you on track through good markets and bad. It’s a way to formalize your asset allocation and remove emotion from investing. As Mr. Bogle often says “Stay the course”. Your IPS can help you stay the course.

My thoughts

Once you embrace the idea that you won’t try to beat the market, just capture its returns with low cost, you are ready for the Three Fund Portfolio. There are more complicated portfolios that may or may not do better. But the simplicity of the Three Fund Portfolio can be valuable, particularly if a spouse without much investing knowledge needs to take over at some point.

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