A lot of investing advice makes portfolios sound complicated. Sector funds, factor tilts, a dozen tickers. For most people saving for retirement, three funds are enough to own thousands of companies and a large slice of the bond market, at very low cost.
The idea is usually called the three-fund portfolio. Here’s how it works and how to set one up.
The three pieces
- A total U.S. stock market index fund. This holds nearly every publicly traded U.S. company, large and small, weighted by size. One fund replaces the need to choose between large-cap, mid-cap and small-cap funds.
- A total international stock index fund. This covers companies outside the U.S., in both developed markets like Europe and Japan and emerging markets. It spreads your bet beyond one country’s economy.
- A total U.S. bond market index fund. This holds a broad mix of investment-grade bonds: Treasuries, government agency bonds and corporate bonds. Bonds usually move less than stocks and can cushion a portfolio when stocks fall, though not every time.
Every major fund company and brokerage offers a version of each, as mutual funds, ETFs or both. The names differ, but you’re looking for words like “total market,” “total international” and “total bond,” and an expense ratio low enough that you don’t have to think about it, often under 0.10%.
Choosing the split
The three funds are the easy part. The decision that matters is how much goes into stocks versus bonds. That mix drives most of how much your portfolio will swing up and down.
There isn’t a correct number, but the trade-off is consistent. More stocks has historically meant higher long-term growth and bigger drops along the way. More bonds has meant smaller drops and lower expected growth. A few things push you one way or the other:
- When you need the money. Money you won’t touch for 25 years can ride out more ups and downs than money you’ll need in five.
- How you’d react to a large drop. If a 30% fall in your stocks would lead you to sell, hold fewer stocks.
- Other income. A steady pension or a stable job can make it easier to hold more stocks, since you won’t need to sell them in a downturn.
Within the stock portion, people commonly put somewhere between 20% and 40% in international stocks. Some go higher, closer to the international share of the world’s total stock market. Some go lower. Any of these is defensible. Pick one and stick with it rather than adjusting based on which region did better lately.
An example
Say you have $50,000 to invest and decide on 80% stocks and 20% bonds, with about a third of your stocks in international funds. That works out to roughly:
- Total U.S. stock: 50%, or $25,000
- Total international stock: 30%, or $15,000
- Total bond: 20%, or $10,000
Someone closer to retirement might use 50% stocks and 50% bonds instead: $17,500 U.S. stock, $7,500 international stock, $25,000 bonds. Same three funds, very different ride.
If your money is spread across accounts
Most people don’t have one account. They have a 401(k), maybe an IRA, maybe a regular taxable brokerage account. You don’t need all three funds in every account. Think of your accounts as one combined portfolio and hit your target split across all of them.
Two practical points come up here.
Your 401(k) menu might not have all three funds. Use what it offers, often an S&P 500 index fund in place of a total U.S. fund, which is close enough, and fill the gaps in your IRA or other accounts.
If you have a taxable account, bond interest is generally taxed as ordinary income each year. Many people prefer to hold bonds inside tax-advantaged accounts like a 401(k) or IRA and keep stock index funds, which tend to be more tax-efficient, in the taxable account. This gets more complicated as balances grow, and it’s one area where a tax professional can help.
Keeping it running
Once it’s set up, the work is small. Add new money on a schedule, and direct it toward whichever fund has fallen below its target. Once a year, check whether any fund has drifted far from its target, say more than five percentage points, and rebalance if it has.
That’s most of the maintenance. The hard part is leaving it alone when one piece has a bad stretch, which every piece eventually will.
The one-fund alternative
If even three funds feels like too much to manage, a target-date index fund holds roughly the same ingredients in one fund and shifts toward bonds automatically as the target year gets closer. You give up some control over the exact mix and usually pay a slightly higher expense ratio. In exchange, the rebalancing happens without you. Just don’t hold a target-date fund alongside other funds without accounting for it, since it already contains its own stock and bond split and can throw off your overall mix.
This post is general information, not financial advice.