DIY 3-Fund vs Target Date Fund
When it comes to investing in the stock market, I firmly believe that the 3-fund portfolio is one of simplest, yet the most effective strategies to follow. Therefore it’s not a surprise that most target retirement funds and target date funds follow this strategy as well. When I look at my own portfolio and compare it side by side with a similar Target Date fund, I find that the asset allocation and the funds are quite close to each other. So the big question is why not keep it simple and just invest in Vanguard Target Retirement Funds?
In today’s post we are going to deep dive into two of the most popular investment strategies: the do-it-yourself, 3-fund portfolio strategy and then set it and forget it target date fund strategy. They both have their strengths and weaknesses and they appeal to different types of people, so let’s take a look at which strategy might be best for you.
3-Fund Portfolio 101
Let's briefly go over what a 3-fund portfolio is. 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. 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 post, there are approximately 4,000 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 post, there are close to 8,000 international companies. 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 post, there are more than 10,000 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. 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.
Target Date Fund 101
Alright let’s talk briefly about Target Date Funds. They are sometimes called Target Retirement Funds or sometimes Lifecycle Funds based on the investment firm, but the premise is the same. And they are also called “fund of funds” because it holds several other funds within it.
The index funds that a target retirement fund holds are most often the same ones we would use for a 3-fund portfolio strategy. However with some notable differences. Unlike a DIY 3-fund portfolio, a target date fund will rebalance the asset allocation of the portfolio automatically as you get closer to your retirement age.
The basic investing philosophy is the same as a 3-fund portfolio, but it makes investing even easier. You can think of it as the poor man’s financial advisor without all the downsides of actually having a financial advisor. If you want to make good investment decisions, but don’t have any desire to learn about portfolio design or investment strategy, this one fund would literally be all you need for the rest of your life. It has automatically built-in-diversification because it holds low cost broad market index funds, and it automatically adjusts asset allocation as you get closer to your retirement age.
A general rule of thumb is that as you get closer to your retirement age, you want to hold more stable assets like bonds and cash versus stocks in your portfolio. A target retirement fund does this for you automatically, making your portfolio more conservative versus aggressive using different asset classes. Assuming I want to retire when I’m in my 60s, my Vanguard specific Target Retirement fund would be Vanguard Target Retirement 2045 Fund, also known as VTIVX.
When we look under the hood of this fund what we will notice is that the funds within VTIVX are actually identical to what we would have selected for our 3-fund portfolio. It’s made up of Vanguard's Total Stock Market Index Fund, Total International Stock Index Fund and Total Bond Market Index Fund. So the big question many of us ask is, if the funds within the target date fund matches that of my DIY 3-fund portfolio, why not just keep it simple and buy Vanguard Target Retirement fund? Set it and forget it, right? Well, it’s not that straightforward. Let’s look at a few criterias that might make you lean one way or the other.
Comparison Criteria #1 - Expense
The first criteria of comparison is expenses. Expense associated with each strategy and how it can affect your portfolio outcome. Most of Vanguard’s Target Retirement Funds have an expense ratio of 0.08%. This means that if you had $10,000 invested, Vanguard is charging you $8 annually to manage this fund for you.
For comparison purposes I’m going to use the Vanguard Target Retirement 2045 Fund’s individual fund allocation and apply it to our own 3-fund portfolio. In this scenario the weighted average expense ratio of our DIY 3-fund portfolio comes out to around 0.066%.
VTSAX has an expense ratio of 0.04%, VTIAX 0.11% and VBTLX 0.05%. For simplicity, I lump the Total Bond Market II Index Fund and the Total International Bond Index Fund into one bond fund, since it is such a small allocation. So by holding 3 separate funds instead of one, we save 0.014% in expenses per year. Now, does that sound small to you or significant? It depends on the size of our portfolio and the time horizon.
Let’s assume an average return of 8.00% for the 3-fund portfolio and 7.986% for the target date fund given the 0.014% difference in expense ratios. And let’s assume that I invest my $1,000,000 today in each fund until my retirement 25 years from now. How much would I have in each fund? For the 3-fund portfolio, the $1,000,000 would have grown to slightly under $7M ($6,848,475). For the Target Date fund, the $1,000,000 would have grown to, also, slightly under $7M ($6,826,315). A difference of over $20,000.
Not a small amount but also not that large in comparison to the total portfolio amount. It all depends on our perspective and how much we have to start out with. Now of course I’m not factoring in rebalancing so it's not a perfect comparison, but the main point is that even a small difference in expense ratios like 0.014% can have some level of impact to our portfolio. But is this enough to say a 3-fund portfolio is better than a target date fund? Probably not. So let’s take a look at a few other comparison criterias.
Comparison Criteria #2 - Tax Optimization
The second criteria of comparison is tax optimization. There are naturally investments that are already “tax efficient” to begin with. Most often these are stocks and mutual funds that pay qualified dividends - dividends that receive favorable tax treatment. And stocks and mutual funds that avoid paying out taxable capital gains distributions. Such distributions are typical of actively managed funds that engage in frequent trading in their portfolios.
Vanguard Total Stock Market Index Fund checks the box on both of these thus is a great example of an already tax-efficient investment. The dividends it pays are modest and mostly “qualified.” And because trading in the fund is rare, so too are taxable gains distributions.
On the other hand, investments that are “tax inefficient” are those that pay interest, non- qualified dividends and those that generate taxable capital gains distributions. Individual Stocks, Bonds, CDs and REITs fall into this category. And because of their tax inefficiency, we would ideally like to keep them in tax advantaged accounts like 401(k) and IRAs.
Now when we are managing our own DIY 3-fund portfolio, we can allocate the different funds to different tax efficient accounts. For example, putting the majority of our bond index fund into 401k and IRA. While being ok putting out equity index funds into non-tax advantaged accounts like simple brokerage accounts because they are already tax efficient.
However, when we follow the target retirement fund strategy, we don’t have this flexibility. We can’t break out the specific sub-funds. Everything goes into each tax advantaged or non-tax advantaged account equally. The scale of the impact is again dependent on the size of our portfolio and time horizon, but the bottom line is that when we manage our own investments, it allows for tax optimization customization.
Comparison Criteria #3 - Asset Allocation
The third criteria of comparison is asset allocation. Asset allocation simply means What percentage of your total portfolio should you hold in total stock vs total international vs. total bond index funds. And this is a crucial component to our investments because based on your life stage, the allocation you decide will have a tremendous impact on your potential returns and ability to retire.
A general rule of thumb you want to understand is the relationship between risk and reward and how it correlates to stocks and bonds. If you want to take more risks with your portfolio, you want to hold more stocks. If you want to take less risk, then you want to hold more bonds. But, when you take less risk, there are also less rewards - meaning potential for high returns. Take a look at the chart here I borrowed from the “Bogleheads Guide to Investing.”
This chart shows maximum annual loss and the average annual return an investor would have incurred during the period from 1926 to 2012 based on various stock to bond allocation. If you were to have been 100% in stocks, though your average returns would have been the highest at 10%, at your worst year, your portfolio would have lost 43% of its value.
Imagine if you were about to retire and your portfolio just dipped by almost half its value. You’d either need to push back your retirement or have a heart attack. Maybe a combination of both. Now imagine that you are very risk averse, so you decided to go 100% bond. Ok, so you are protected from the worst annual loss to just 8%. But, your average return is only 5.5%.
By being so risk averse, you missed out on much of the gains from the market. So based on your life stage and risk tolerance, you will need to decide how much bond and stocks you feel most comfortable with. Are you the type that’s ok with riding the high ups and downs of the market without letting your emotions get to you?
The worst thing you want to do when the market is down is to sell. Actually this is the time you want to be buying because the market will eventually recover and you want to take advantage of that ride up. And this is probably the biggest disadvantage of owning target date funds. You are not in control of your asset allocation. The willingness to take on more or less risk is a very personal preference. You could be a type that loves taking risks.
Or you could be the complete opposite. Completely fine, not taking any risks. We are all very different individuals when it comes to our risk tolerance, and when you invest in Target Retirement Funds, you can’t factor in those personal preferences. The fund has a risk profile formula it follows and you can’t change that. And you have to live with the consequence of that asset allocation.
However with a 3-fund portfolio, you can customize your portfolio in ways that are not available with target-date funds. Alright, so based on what we covered so far - the additional expense ratio, tax optimization and the lack of customization, does a 3-fund portfolio trump target date funds? Well not completely. Because I do believe there are good scenarios for target date funds.
When Does Target Date Fund Make Sense?
Struggle With Analysis Paralysis
The first scenario where a target retirement fund makes sense is if you are struggling with analysis paralysis. If you are reading all these articles and delaying your investment because you are trying to find the “perfect” investment, I would say just buy a target retirement fund and get started. There is no such thing as perfect investment. Just one that works for you.
Analysis paralysis is what keeps many people from investing in the market. We are all afraid of making big mistakes. However, the best way to learn is through action. Yes, you need some base of knowledge before jumping into the deep end of the pool. However when it comes to investing, the difference between a DIY 3-Fund Strategy and a Target Retirement Fund is irrelevant when compared to not investing at all.
When you commit to investing, you will naturally learn more. There is something about having real money in the market that focuses our attention. And know that just because you choose the target retirement fund strategy today doesn’t mean you can’t change it down the line. For me, this is what I personally did in order to just get started.
I didn’t know where to start so I started investing in a target retirement fund so I wasn’t constantly sitting in the sideline. After a few years, as my knowledge grew, so did my confidence and I was able to transition to a 3-fund strategy. But this took time and if this is you, I would recommend starting out with a target retirement fund strategy so you get the ball rolling.
Want To Save Time Above All Else
The second scenario where a target retirement fund makes sense is if you want to save time above all else. As I mentioned earlier, a target-date fund is like a poor man’s financial advisor. With just one decision, the target retirement fund will give you a diversified portfolio, rebalance it for you, and ensure you stay the course. All for a great price of just 0.08%.
All you have to do is just keep investing. If you want to be completely hands off and save time above all else, this could definitely be worth it. I mean it surely beats paying some real financial advisor to do many of the same things but charge you 1 to 2% versus 0.08%.
Fear Self Sabotage
The third scenario where a target retirement fund makes sense is if you fear self sabotage. The 3 fund portfolio is great because it allows us flexibility and freedom to customize our asset allocation. However, this could be a double-edged sword.
If you are a new investor and haven’t experienced many ups and downs of the market, you could overreact to certain market corrections. For example, let’s say you never experienced a bear market. Then you might start out too aggressive in your 3-fund portfolio in relation to your risk tolerance.
So when a market crash happens, which it always will, you might overreact and swing to becoming too conservative afterwards. Holding all your money in cash because you didn’t enjoy the roller coaster ride. In this case, a target retirement fund could be a good strategy because it will force you to stay with a specific asset allocation regardless of how the market is doing.
