You don’t have to be a professional on Wall Street strategically picking stocks and analyzing the financial markets to generate long-term returns. In fact, taking a more hands-off, lazy approach to investing instead of buying and selling on market moves may be the key to making you rich.
Earning enough to make long-term goals like retirement a reality requires staying consistent and diversifying. Here’s how to do this with the three-fund portfolio strategy.
The three-fund portfolio
Each investor’s plan should be based on their unique goals, risk tolerance and time horizon. But for some, a low-maintenance, three-fund portfolio can do the trick.
The three-fund portfolio consists of the following:
- A U.S. total stock market index fund
- An international stock market index fund
- A total bond market index fund
Many brokerage firms offer these index funds in the form of exchange-traded funds (ETFs), and they usually come with low expense ratios.
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The pros of the three-fund portfolio
The low expense ratios are a major perk of this portfolio. But another reason this strategy can work is its diversification and the long-term approach. Diversification involves putting your money into a variety of assets like small-, medium- and large-cap stocks from the U.S. and abroad, as well as bonds, to reduce risk. The idea is that when one area of your portfolio performs poorly, another will hold steady or even outperform, reducing overall risk.
This is the type of strategy that doesn’t produce life-changing returns right away, but the compounded growth over many years can result in a sizable nest egg by the time someone is ready to retire. It’s important to stay the course during the market downturns so that you can benefit during recoveries.
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The cons of the three-fund portfolio
Like with most investment strategies, this portfolio won’t make sense for every investor. As experts at Morningstar point out, it may not make sense to use this portfolio in taxable accounts, since a taxable-bond fund will generate income distributions that you’ll have to pay taxes on. Plus, you won’t necessarily have the same high growth potential of growth-oriented funds, and you won’t get exposure to alternative investments.
Keep in mind that you still need to rebalance regularly when you implement this strategy, since one portion of your portfolio may grow too large in value compared to another, increasing risk.
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How to set up the three-fund portfolio
Setting up the three-fund portfolio can be fairly simple. The first step is to choose a low-cost brokerage account like Vanguard or Fidelity Investments.
Then, decide how you want to allocate your capital based on your risk tolerance. Putting 60% of your funds into stocks and the remaining 40% into bonds is a common strategy. Investors who have a higher risk tolerance may lean more into stocks, while risk-averse investors will likely opt to allocate a higher percentage to bonds.
Finally, you can set automatic contributions so money from your bank account automatically goes towards your investments. You can conduct a regular rebalance based on changes in your portfolio and risk tolerance. Investors typically put more money into bonds as they get older, especially if their stock positions have rallied recently.
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