3-Fund (+1) Portfolio Strategy
Jack Bogle, the father of index funds is famous for saying:
“Simplicity is the master key to financial success.” - Jack Bogle
And there is no simpler, and effective investment portfolio than the 3-fund portfolio. By owning just three simple low-cost index funds, a Total U.S. Equity, a Total U.S. Bond, and a Total International Equity, all of us can outperform the vast majority of mutual funds out there.
But what if we want to add a bit more flavor to our 3-fund portfolio? You got the 3-fund portfolio down, but you like to jazz it up a bit. What would be a good addition?
So in this post we are going to talk about the 5 most popular 4th additions to the 3-fund portfolio strategy.
3-Fund Portfolio 101
The 3-Fund portfolio was made popular by the Bogleheads - the self-proclaimed avid followers of Jack Bogle, the founder of Vanguard group. They preach index funds as a sure way to build wealth and advocate for the 3-fund portfolio strategy as a simple, but one of the most effective ways to manage our investments.
I don’t know if I would go out my way to call myself a Boglehead, but I do align myself with a lot of their principles. As stated earlier, Jack Bogle, the father of index funds, is famous for saying: “Simplicity is the master key to financial success” and I completely agree with this statement. The three fund portfolio that the Bogleheads so highly praise is, as its name implies, is made of three simple index funds: a Total U.S. Equity, a Total U.S. Bond, and a Total International Equity fund.
A total US Stock Market Index Fund essentially holds every single stock in the US stock market. At the time of this video, there are approximately 4,000 (4,028) publicly traded companies in the United States. Think of popular stocks like Apple, Google and Amazon as well as some lesser known ones like Dollar Tree or M&T Bank. A specific Vanguard fund would be Vanguard Total Stock Market Index Fund, also known as VTSAX.
A total International Stock Index Fund would include all stocks from the rest of the world excluding the ones headquartered in the United States. At the time of this video, there are close to 8,000 (7,985) international companies in this one fund. They include some familiar companies like Samsung, Nestle and Shell, as well as thousands you might not know even existed. A specific Vanguard fund would be Vanguard Total International Stock Index Fund, also known as VTIAX.
A Total US Bond Market Index Fund would include all types of bond you could think of. Varying credit quality ranging from US Government to Triple B and varying maturities from short term to long term. At the time of this video, there are more than 10,000 (10,220) bonds within this fund. A specific Vanguard fund would be Vanguard Total Bond Market Index Fund, also known as VBLTX.
Like a good cake, when you mix these three into a single portfolio, you get the ultimate, DIY 3-fund portfolio with close to 22,000 different securities. And the basic premise with this strategy is that if you were to follow this simple plan throughout your investing journey, you will almost surely not only beat out the majority of stock picking investors out there, but even the most professional investors.
Alright with that said, let’s say you want to add a bit more flavor to your portfolio cake. You want to jazz it up a bit. And nothing wrong with that as long as you are still maintaining the 3-fund portfolio as your core holding. You just want to ensure that additional holding helps you to expand the portfolio beyond the core securities, without replacing them. Alright, with that said, let’s go over 5 most popular ones.
01 - REIT
A REIT is a company that owns, operates, and finances income-generating real estate. But what we really need to know is that they are modeled after mutual funds. So buying a REIT is similar to buying index funds. Index funds allow us to buy publicly traded companies without buying individual stocks. Similarly, REITs allow us to tap into real estate investments without having to actually buy, manage, and finance any properties ourselves.
Vanguard offers a solid REIT, the Vanguard Real Estate Index Fund also known as VGSLX. It has an expense ratio of 0.12%. Which means if you have $10,000 invested in Vanguard Real Estate Index Fund, you are essentially paying $12.00 for Vanguard to manage this fund for you. In addition, like many Vanguard funds, it has a minimum investment of $3,000.
It represents close to 170 (167) real estate companies that represent all different types of property investments in the real estate industry. Properties such as office buildings, hotels, and even residential homes.
If you have a complete 3-fund portfolio but want to add some real estate flavor to your investment portfolio, a REIT could be a good starting option. REITs have often performed differently than stocks and bonds, so this fund may offer some diversification to a standard 3-fund portfolio. I wouldn’t make this a core holding in your investment portfolio, but it's good to consider it as an added diversity to your overall wealth.
02 - Rental Property
Physical real estate property in general has a lot of benefits. For one when you rent it out to a tenant, there is cold hard cash income. Income that you can use however you see fit. Second, unlike other assets like stocks and bonds, a physical real estate is something you can even use personally if need be. My wife and I personally own rental property out of state and we often joke that if the worst comes to worst in California, we can always move into our less costly rental property.
Another major benefit to owning rental property besides the rental income is that if you manage your property correctly, you will have other people helping you to pay off the mortgage while you enjoy the long-term price appreciation on the property. Additionally, if you borrowed money when purchasing the property, your return can be magnified due to the leverage.
Let’s look at an example, let’s say you put down $50,000 for a $250,000 property. This means you borrowed $200,000 from the banks. Now a year later your property value appreciated by 20% to $300,000. If you were to sell this property now, you would have made $50,000 profit from your $50,000 down payment investment. Essentially a 100% return.
How long would it take to get a 100% return in the stock market? Definitely more than a year. Now if this sounds way too good to be true, don’t worry, it is. Debt, also known as leverage in this scenario is a double edged sword. It can help you gain a 100% return in this case, but it can also work against you if the value of the home drops.
For example, let’s say the price of your home fell from $250,000 to $200,000 and you sold the house. Your initial down payment would be essentially gone because you still owe the bank $200,000. Another thing to note regarding owning real estate is that it requires a lot of hands-on activity compared to other investments like index funds.
If you are managing your own property, you need to deal with tenants, list the property for future tenants, provide ongoing maintenance and much more. However, if you are wise with your purchases. Meaning you aren’t taking unnecessary risks and you have enough cash to ride the ups and downs of the economy, real estate can be a positive benefit to your overall financial portfolio.
03 - Small Cap Index Fund
A good Vanguard representative fund would be the Vanguard Small-Cap Index Fund, VSMAX.
An ETF equivalent is Vanguard Small-Cap ETF (VB). VSMAX has an expense ratio of 0.05% and like many other Vanguard funds, has a minimum investment requirement of $3,000. VSMAX has 1,500 (1,495), what finance people call small-cap companies.
In the finance world, companies get categorized based on the size of their market value. Large cap, Mid-cap and Small cap. Large cap companies are companies valued more than $10 billion. Think of big boys like Apple, Amazon and Microsoft. Mid-cap companies are companies with market capitalizations generally between $2 billion and $10 billion. Some companies classified as mid-cap include First Republic Bank, Dollar Tree, and Devon Energy Corp. You might have heard of them, but likely not. And small cap companies are companies generally valued between $300 million and $2 billion. You probably have not heard of many of these companies unless you’ve been following them for a particular reason.
As you can imagine, different sized companies operate differently and therefore likely affect their future performance. A big company might not have the aggressive growth trajectory like a small up and coming startup. And investors often look to mid-cap stocks as being more stable than small-caps, while providing stronger growth opportunities compared with large-cap companies. Though this is hard to predict given many of the large companies these days are technology companies, and they move at their own pace regardless of their size.
If you are the type that likes to slice and dice your portfolio into different classes, and you are holding a large cap equities fund, like the S&P 500 index fund as your core equities holding, a small cap fund could be a good 4th addition to your 3-fund portfolio. Small-cap companies, though may experience more volatility and pose higher risk to investors have the potential for high rates of growth.
Just to give you additional context to why anyone would want to do this. Meaning why hold multiple equities funds instead of holding one total stock market index fund like VTSAX. The reason is because of the weight given to market capitalization. Because of market cap, a fund like VTSAX’s mid-cap and small-cap company representation is limited. Again, some people like to slice and dice their portfolio allocation more than others. I’m in the camp of less is better, but again no judgment here.
04 - Mid Cap Fund
A Vanguard representative fund would be the Vanguard Mid-Cap Index Fund, VIMAX. An ETF equivalent is Vanguard Mid-Cap ETF (VO). VIMAX has an expense ratio of 0.05% and like many other Vanguard funds, has a minimum investment requirement of $3,000. VIMAX has around 350 (357) mid-cap companies. The reason to add VIMAX to your 3-fund portfolio would be identical to adding a small cap fund.
When we look at history, there have been times in history when small-cap and mid-cap companies have done a bit better than large-cap companies. And again, though there are thousands of small and mid cap companies represented in a total market fund like the VTSAX, they still hold a minor position in your overall portfolio because of market capitalization. You can gain greater exposure to the small-cap and mid-cap companies by holding small-cap index (VSMAX) or mid-cap index (VIMAX), or even both.
05 - International Bond Index Fund
A Vanguard representative fund would be the Vanguard Total International Bond Index Fund, VTABX. An ETF equivalent is Vanguard Total International Bond ETF (BNDX). VTABX has an expense ratio of 0.11% and like many other Vanguard funds, has a minimum investment requirement of $3,000.
This fund is designed to provide broad exposure to non-US investment-grade bonds. The fund seeks to track the performance of an index that includes international government, agency, and corporate securities, mostly from developed countries, but also some emerging markets countries as well.
VTABX represents close to 7,000 (6,863) bonds from government, government agency, and corporations all from approximately 40 non US countries, and all issued in currencies other than the US dollars. The 3-fund portfolio already holds bonds as one of its core holdings, but an addition of an international bond fund increases your pool of investments and can help smooth overall returns.
In addition, some exposure to international bond funds can help buffer our portfolio against the US specific risks. For example, there have been times when inflation ran higher in the United States than other parts of the world. Of course this can work the other way as well.
What is interesting is that Vanguard already includes the Total International Bond Index Fund in many of its target retirement funds. Though not a major percentage, a nice added diversification.
You can’t go wrong with a 3-fund portfolio, but some added diversity, as long as it's kept in check can be a nice addition. Who says a little bit of Kimchi can’t go well with meat and potatoes right?
