How to Create a 3 Fund Portfolio | A Beginner's Guide

Hello everyone, welcome back to the financial freedom program. My name is Rob Berger. In today's episode we're going to delve into what's called the three-

fund

portfolio

. It is a simple, low-cost but powerful and I would say even sophisticated way to invest. I think it should represent the core of anyone's

portfolio

. I can tell you that it represents the core of our portfolio and that wouldn't change if I had a billion dollars to invest. It's funny how when you can grow your assets and you have more and more money all these advisors want, they want to get fancy with us and split their portfolio into 15 or 20 or 50 different

fund

s and it's a lot of nonsense that a portfolio of three funds gives us give everything we need to invest our money. whether we're investing a thousand dollars one hundred thousand one million ten million it doesn't matter so this is what we're going to do in today's video first we're going to talk about what the three fund portfolio is going to talk about Is it diversified?

Actually, we'll look at the numbers and then we'll look at historical returns. How has this three-fund portfolio performed over the past few decades? So that's the first part and then we'll see Actually, in how to

create

it, we'll see specifically how much we allocate to each of the three funds that we're going to talk about that make up the three-fund portfolio which will be the first thing and the The second thing is what funds we should use. I mean, should we use Fidelity Vanguard? You know what Blackrock? What funds should we use to build this portfolio?

Let's talk about that and then I'll explain how to build it for you. I mean, it couldn't be easier. I'm going to

create

it for you on m1 Finance. I guess it is one of the newer online brokers. If I were starting from scratch today, I would use m1 Finance without a doubt and that may surprise some of you because you know I'm a die-hard Vanguard fan, but here's the deal: you can invest in Vanguard funds on m1 Finance. You don't actually have to open an account at Vanguard and, particularly for

beginner

s, frankly, there are good reasons to favor m1 Finance. about some of the more traditional brokers, let's talk about that, then I told you this was a deep dive, then we'll look at ways that you can really supercharge the three fund portfolio and add a few more things to it that I think gives you a good opportunity to increase your long-term returns without significantly increasing volatility.

Well, let's get right to the point and start with what a three-fund portfolio is. It's really simple, it's a portfolio where we only have three. They could be mutual funds or ETFs, one covers US stocks, which are shares of publicly traded companies that are based in the United States, so think about Amazon and Apple and believe it or not, there are many companies that You and I have never heard of it, so that's the first group. We could call it right or mutual fund number one, so we want one that covers all companies based outside of the United States, so some type of global or international fund is number two and the third is simply a bond fund and here you can get them all.

Well, I mean there are emerging market bond funds, international bond funds, but US folks, I think it's better to stick with some kind of US total market bond fund, you'll invest in some government bonds, some corporate bonds, but you can. do it all within one fund and that's it, those three funds and that's it, it's really that simple now we use index funds and that's important because index funds, for two reasons, are much less expensive than actively managed funds and They outperform and typically over the long term, even compared to really good actively managed funds, index funds tend to outperform actively managed funds on cost, the difference in fees, which is usually about the difference and you know when you're paying five. or ten basis points for an index fund and you are paying one percent or more for an actively managed fund.

That difference may seem small, but if you've watched this channel long enough, you'll know it will result in a loss of hundreds. of thousands and even millions of dollars over the long term, okay, so that's it, that's the basic redemption portfolio. I wish I could make it sound more elegant and complicated, but it's not, and yet it can actually give you an incredibly diverse portfolio and one that has excellent returns, so let's dive into that now, how should we think about the diversity of a portfolio? of three point funds? In fact, I'm going to turn on my monitor here for you, we're looking at one of the funds that you could use.

We're going to look at a lot of different ones here in a minute, but one of the funds that you could use to create a three-fund portfolio is the cutting edge total stock market index and let me show you how I got here. I know. this is the ticker that is here vtsax. I know this because I own shares of this fund so you can google the ticker and you will get a good snapshot of the fund and here is the link to the vanguard where we were. in and we go back there, that's how I got to this screen and if we want to know a question could be, is it just a fund, that is, how many stocks can you actually invest in, well, we can figure that out if you just go to the portfolio tab and we We scroll down, there's the number of stocks, I mean, they couldn't make it any easier, they put it right there, 3640 companies, so in one fund it invests in over 3600 companies and if we want to look at fees and this is just extraordinary, look at the cost, that's four basis points you get, you can invest in over 3,600 funds for just 0.04, it's extraordinary now, so that's an example of one of the right funds you could invest in. a three fund portfolio with over 3600 stocks, let's look at the international version, which I think is v t i a x.

I should know because I think I own shares of this one too. uh, yeah, here it is, so we'll go to the vanguard page again and like that. This could be the second fund in our example and it will cover international stocks and if we go to the portfolio we will see that it will have even more, yes, seven thousand right here. There are 7,361 stocks in this fund and the fees. just 11 basis points right here just extraordinary uh we could do the bonds just to close this vbtlx I also have shares of this just full disclosure and go to the total bond market again we are looking ahead and if we showed up By the way, passing to the portfolio, I can tell you that this will have even more because in a bond fund there are a lot of bonds available, so let's see, yes, 10,025 bonds and if we go to the fees, they could be a little bit higher. there's no five basis points, so, I mean, that seems pretty extraordinary to me, right, you have three funds, think about it, we have over 10,000 stocks and over 10,000 bonds with just three funds that cost four basis points, five points basics and me.

I think it was 11 basis points, so here's what to keep in mind: You can't determine the diversity of a portfolio simply by looking at the number of funds. I have seen advisors and it still makes me angry that they put a client on. like 20 different funds, they will charge the client one and a half percent, the average expense ratio of these funds is one and a half percent and they are no more and many times less diversified than what I just showed you on the screen . with a three fund portfolio, frankly I think that's criminal in any case, I'll get off my soap box, a three fund portfolio is a beautiful thing, incredible diversity, it's simple, it's easy to manage, can you imagine trying rebalance a portfolio with 20 funds actually m1?

Finance makes it easy, that's another story, we'll see, but still with only three funds it's as easy as it gets. Its low cost. I think it's a great way to build, if not your entire portfolio, then at least the core. of your portfolio, having said all that, the big question is what are the returns, so let's go back to the screen here and I'm going to move over here to what's called the portfolio viewer. It's a free tool and I use it a lot and they really make it easy to see the historical returns of a portfolio of three funds.

You can actually compare three different portfolios and we'll use that feature in a minute, but to get started, if you click this button, you can customize it. you can choose any asset class you want and what percentage etc etc but there are also some kind of pre-filled portfolios and you can select them properly and one of them is bogle. he heads the three fund portfolio if you're not familiar with bogleheads it's named after jack bogle the founder of vanguard they have an amazing forum it's just an amazing group of people that will help new investors but you can google bogleheads and you just get a ton of wonderful information.

I'm a big fan anyway, if we just click on that, it prepopulates not only the asset classes and there they are, we've already talked about them, U.S. stocks, global stocks, total U.S. bonds. and they've filled out a percentage, we'll talk about that in a minute, but this is kind of a standard three fund portfolio 50 in US stocks 30 in global stocks 20 in bonds now we'll look at this from 1972 all the way up to the current year 2021. That's what older than the data comes in, but it's quite long, but keep in mind that date, we'll come back to it in a minute, we'll assume an initial investment of 10,000 and We're not going to assume any additional investment, so how did you make this portfolio?

Click the Analyze Portfolio button. The first thing I want to point out is that the results don't start until January 1980, although if we go back here we set it to start in 1972. What's happening? Well, you can see the explanation here. One of the asset classes that we were using in the total US bond market is this one right here. They don't have data going back to 1972. They just have data. We go back to January 1987, so sometimes you may want to have a longer period. The tool adjusts itself according to the data it has for our purposes.

Okay, we are still looking at 30+ years and we can see if an investment of 10,000 would grow to over 168 thousand dollars and this means a compound annual growth rate of 8.64. If you think about it, that makes sense. Long-term stocks typically return around 10, but we also have bonds in this portfolio 20 allocated to bonds to cushion a little bit of volatility so we can sleep at night and that's our compound annual growth rate. Excellent performances. I can't imagine any active manager with the same asset allocation outperforming that performance over the last 30 years. Remember. this number 8.64 I want to come up here and make a slight change in our assumptions, most of us don't invest a lump sum at the beginning of our career and then never invest again, at least no one I know does.

We're putting some money away in our 401k each month, maybe an IRA, maybe taxable accounts, well we can model that with this tool, so let's contribute an amount that we're going to say we're going to contribute, we'll call it 500 dollars a month. Obviously, you can use this tool and change any assumptions you want. We will adjust contributions for inflation, so that's good, we will do it monthly instead of annually and we will rebalance the portfolio annually. That's good, remember our annual compound. the growth rate was 8.64 now, look what happens, it jumps to 16.12, holy cow, that's huge and look at our balance, you know it was up to 168 grand, you know, we invested 500 dollars a month and it jumps to 1, 6 million, that's right.

Clearly, this calculator is broken, it's not broken, the calculator is working fine, let's go back to the calculator first, it shows us the power of compounding even on relatively small amounts of money, $500 a month, and the reason why compound annual growth rate changes is because when you start investing a flow of money, let's say monthly, you are investing in good markets in bad markets, we can look down here, there were different dips, this was in the period 0-809, this was the tech bubble when it burst. then you are investing in really bad and good times and that will affect your performance.

We all know that it is better to invest when the market is down. I think for most of us we just use dollar cost averaging and that affects the annual compounding. growth rate of a portfolio, so the real conclusion is that the three-fund portfolio has performed exceptionally well over the past, in this case, more than three decades. We could go back further. There are other ways to model the three-fund portfolio and it works very well. Alright, that's how it's been done for the last 30+ years. Now let's sort of transition into that big robbery. How do I create one?

I want to start with asset allocation, so let's go back to the portfolio viewer. Remember that I pre-formatted this or pre-programmed it if you want by simply using the Bogel Heads three-fund portfolio and it automatically filled in these percentages. The most questionWhat's important is whether it's true, whether you use a three-fund portfolio or something else. The most important question. As investors, we're going to ask ourselves if our asset allocation between stocks and bonds is going to be more important than international small caps versus small caps versus large caps. Those are important questions too, but they're not as important as stocks versus bonds, so that's really the first question we all need to answer for ourselves.

Let's make some different assumptions. First let's imagine a 90 10. Remember this is 80 20. The 50 and 30 are for stocks that add up to 80. The 20 are bonds, so let's make a 90 10 so we can do that. I'll say 55 here, 35 here and then we'll reduce it to 10. All right, that's our 9010 portfolio and then we can go the other way to get a 70 30 portfolio, so this is going to go to 45, right? I'm just subtracting 5 from the 50 here this will go to 25 and then we'll increase it to 30 and yes they all equal 100 okay and let's compare the portfolios and again we're looking at 87 until 2021 we have our different portfolios here and we can look at the returns , I'll try to keep this on one screen as much as I can, in fact it just appears here.

We know that portfolio one was the one we started with. Portfolio two was the 90 10 portfolio, so our returns increased on our annual compounding. the growth rate increased, it wasn't a big difference, although that may actually surprise people, eh, they're kind of big and they have 100 stocks or 90 stocks, yes, the returns are higher, but not dramatically, and you know , the standard deviation actually appearing here ranges from 12.13. to 13.65, if you're not familiar, you could look at it as a measure of volatility, the higher the number, the more volatile and when you look at the peak drawdown of the actual worst year, um 49 versus 43, call it 44 percent, that's quite a bit significant. now if we go down to 70 30 uh of course the yields are lower and the compound annual growth rate drops below 16 it's still not a big difference and yet the standard deviation look at this it drops from 12 or 13 down to about 10 and a half 10.65 is a pretty significant drop, so I'm showing you this so you can figure out what's best for you.

I'll tell you when they let me come back to the screen here when I was younger and didn't have as much. I had a lot of gray hair, I was 90 10 and it served me very well. Would my life have changed if I were 80 20? No, probably not, I probably wouldn't have changed much if I had a portfolio of 70 30, which is about, I'm probably more like 80 20 right now I'm moving towards 70 30 but of course I'm probably older than most people who watch this video. You have to make this decision for yourself. I can't answer that question for you. You can certainly go out and talk to an advisor and he or she will give you their opinion, but at the end of the day, even then you have to make that decision.

I personally think that all of these portfolios that I've shown you and let's get back to the screen are perfectly reasonable options that I would prefer. be closer to the 80 20 or 90 10 portfolio, but that doesn't make it right, it just makes it right for me, but this gives you an idea of ​​the data, the volatility and the returns. Are we guaranteed to do all this? will repeat itself in the next 30 years, of course, no, we all know that's not true, but I think it's the best data we have, it was obtained over a long period of time and it gives you an idea of ​​what to expect, so I think 80 20 is is a sweet spot, but again you know you have to make this decision for yourself, but there is data to do so now.

With all that being said, the next big question is which funds to use well if you are investing in a 401k of your choice. Funds are determined by your employer and whoever manages your funds, let me say one thing about that. So far, for US stocks, we have looked at a total stock market index fund. I guess in your 401k you may not have that option, but you have an s p 500 index fund, it's a perfectly reasonable option, yes, it doesn't have, you know, 3600 companies, it has about 500, but it's still incredibly diverse and, Frankly, the long-term returns and volatility of a S p 500 index fund is very similar to a US total stock market fund, so don't worry about that decision - it's obviously one you should make if you're out of a 401k and you can choose between two options or if you are in a 401k and they have both options, don't lose sleep over the decision, I would personally choose a total stock market fund because it includes some mid and small cap, but, Frankly, it probably won't make much of a difference to your portfolio in the long run.

If you're out of the 401k, you now have some options to go with Vanguard, go with someone else. This is what I'm going to do. I'll leave a link below the video to the article I wrote. This same topic, in fact, I will show you on my iPad. Believe it or not. I take some notes before these videos and you can see some of the options that I'll show you. see in the article here are the cutting edge mutual funds and their etfs here is the fidelity they have both they are zero funds and they are also kind of funds you could call them more standard funds because of the way their standard funds like the total fidelity market index follows a well known index, their zero funds actually follow a proprietary fidelity index, it's one of the reasons they don't charge expense ratios in any case, maybe that's for another video, uh , charles schwab, i have thrift savings plan, i know a lot about you, uh, he works for the government, uh, he's in the military, thank you for your service, he works at the post office, thank you for your service, the plan savings savings is here, row price, so I give you specific funds with the tickers with the ticker symbols so you can create a portfolio of three funds regardless of where you invest and what you want to invest in, all of these are low cost, so I think they're all great options right now, having said that I mentioned m1 Finance And I really want to show you how to build the three fund portfolio within m1 Finance and then I'll talk to you about why I like m1 Finance so much and frankly, of Vanguard.

If you're listening, add some of these. tools to stay ahead would really make my day and make our lives as investors a lot easier so let's go to the computer again and we're where we were on my m1 finance account let me log in. Again, you'll notice I have a big zero. I've been using this for a while to test it out. In fact, I love it. It moved my investments, the small amount of investments I had there, to be ahead of what I'm actually going to do. What we do is we move here about twenty thousand dollars, which represents my investments in the money that I have saved from credit card rewards that I save, we save and invest all of our credit card rewards, we have done it now, I think we're in year three and we're up to 20 grand, so I'll have more on that in a future video, but this is what I want to do.

In fact, I'm going to click on my joint account so my wife can be involved and so creating any portfolio in m1 Finance is very easy, but let's quickly create a portfolio of three funds, so the first thing to do do is go to this research tab and we can see my cakes, that's what they call them. You can think of each pie as a portfolio or even your own mutual fund. You can see that I have a portfolio of four, five and six funds. I'll show them to you in a minute and give you links to all of them. of these in the notes below the video, but let's create a new cake, so we'll come here and we have to search.

In this case, I'm going to use vanguard etfs, so for the total stock market it's vti and here it is. and I'm going to add it to the cart and then I'm going to search. I know the symbol for this, but let's assume I don't. This is total cutting-edge international action. In fact, we can search by name, international total, uh here. It comes right up top, let's add that to our basket and then the last one, I'll just use the ticker symbol and it's your total bond fund, add that to the basket and we can see down here that's all three funds. let's add them oops there we go and here they are now you'll notice that what they've done they've pre-populated the percentages uh for us we're going to change that thing to take into account and this is actually like a beautiful feature of m1 Finance, one of the reasons For the ones I like, if you invest 25 dollars, 100 dollars, a million dollars it doesn't matter in this pie in your account, m1 Finance will automatically divide it by any percentage. you set the other thing they'll do is imagine you do that and a year later the markets have gone up, they've gone down and your allocation is a little bit out of whack now, whatever you set it to, it's changed, my stock has gone up. bonds have gone down or whatever and you decide to invest more maybe you're doing a monthly plan or whatever when you make a new investment they don't just divide it equally between the different investments, they look at which investments have deviated from your plan and They invest your new money accordingly to start aligning your portfolio back to your initial asset allocation, which is a beautiful thing, it's just one of the other features I love about m1 Finance, there's one more that appears when As for rebalancing , I'll get to that in a minute, but first let's fix these target percentages, so if we edit it, we'll get this cool feature and we can change it, so we'll follow the standard boglehead approach which is an 80 20 with 50 in US stocks and then 30 in international stocks and we're going to give it a name, let's call it three fund portfolio and we'll save it and that's it, now it's that simple, um like I said I'll give you a link to this portfolio.

If you are already an m1 finance account holder, you can use this on your existing account if you are new. You can add this as part of creating an account or you can check out these portfolios even if you're investing elsewhere just to get an idea of ​​how I've built them back up. I'm not suggesting they are suitable for everyone, you should make your own decision about what is best. for you, but I think these are great core portfolios or could even represent the entire portfolio and one thing I will mention, let's get back to the cakes, let me open this one up again, you don't see it here because I haven't added it. this to my portfolio or money added, but the other thing that makes m1 Finance so great is that you can literally click a button and it will rebalance your pie, as they call it your portfolio, you know there's no way to take out the sheet of calculation or paper and pencil and figure out, okay, I need to sell how many shares of this fund to move into that fund, just click a button now, if you're in a taxable account, you want to make sure you know the tax consequences. . of rebalancing in a rage for example, of course there isn't one, so again this is where I hope Vanguard will see this video, maybe send it to my friends at Vanguard.

I mean, why can't Vanguard have this video with one click? Rebalancing is not that complicated, yes, if I were starting from scratch that is another reason why I would use m1 Finance. Well, I mentioned at the beginning of the video that we were going to look at how to supercharge your three-fund portfolio. Not necessary, I think a three-fund portfolio is fantastic. You could go for that, but I tend to use a six-fund portfolio again on m1 Finance. It would be incredibly easy, but even in a traditional broker it's not that difficult to manage. six mutual funds, but I think you could add up to three different asset classes to a three-fund portfolio to, as I say, boost returns, so let's look at those, we'll go back to m1 Finance and look at these.

Other cakes, let's start with the fund portfolio. What I add, you can see it down here, is I add small cap value and I add 10, so I lower my total US market fund from 50 to 40 and I add 10 percent to small cap. value what we know from history is that small cap value, while a little more volatile, returns are expected to be higher than, say, a s p 500 now, not always in recent years, stock companies great growth have been on fire, as we know, but for a long time. The term small cap value tends to work very well.

You know you could go with just a small cap that isn't tilted towards value. However, I think it's also a reasonable choice in this cake, and by the way, I'm still getting used to what these cakes are called. In this pie I use a small cap stock and what I'm going to do in this podcast article is I've done some profitability analysis using the portfolio viewer and I'll include images of all of that in the article that I can verify, so that It's bottom four. I'll go back to the pies here, let's open five uh fund, what I do here, I keep ten, ten percent in small caps, you see it here, but I add ten percent to emerging markets and To do that, I lower the stocks international 30 to 20.

And emerging markets is more orminus the same argument as small cap value: they are very volatile but have high expected returns and remember our concern is not anyone's volatility. investment or asset class, our concern is the volatility of the portfolio as a whole and the good thing about this type of low-cost asset allocation investment is that a very volatile asset class can be added to a portfolio without significantly increasing the volatility of it. portfolio as a whole because it's just one ingredient in a much larger portfolio, so if I were to make five funds it would add small cap and emerging markets value again.

I'll leave a link to this portfolio below the video and finally the last one is the six fund and what do I add, I add reits right here is v and q is the etf version and to do that I reduce the total stock market fund again from 40 to 30. One thing I would caution them is that you don't want to have REITs in a taxable account. It's brutal on taxes, they have to distribute 90 of their profits as income to maintain the benefits that the IRS gives to REITs and they are usually taxed as ordinary income, so you don't just want to use this in a taxable IRA type account deferred if you are investing in a taxable entity. account, I wouldn't choose this six-fund portfolio, I would stick with a five-fund portfolio or just have my real estate allocation in a different account, you know, the 401k if I have one or an ira, but you don't want to hold reits in one taxable account well there you have it, I know it's a deep analysis, but I think it's important that we not only understand what a three fund portfolio is, but also understand if it is diversified, what are the expected returns, how can? believe one, what are the asset allocation options we have?

You know part of that is taking the mystery and fear out of investing. This isn't complicated, but you know there are some things you should know once you know, it's pretty easy, you know when. someone says, hey, my small cap value fund was blah blah blah, well you know what a small cap value fund is, so that's helpful anyway, there you go, if you have any questions, Leave it in the comments below. I will do my best to help you. Come out again, I'll also have a bunch of links below and if you haven't subscribed to the video and you've made it this far, I mean, why don't you subscribe now?

What do you have to lose? Hey, thanks for watching and until next time remember that the best thing money can buy is financial freedom.