Review: The Bogleheads’ Guide to the Three-Fund Portfolio

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The latest entry in the Bogleheads’ Guide series of investment books, The Bogleheads’ Guide to the Three-Fund Portfolio, by Taylor Larimore, published by Wiley, is a short book devoted to a simple portfolio (targeted to US investors) made up of three total market index funds:

  • A US total stock market index fund;
  • An international total stock market index fund;
  • A US total bond market index fund.

The portfolio mix can be varied to accommodate an individual investor’s tolerance for risk.

Sample three fund portfolios

The three-fund portfolio, as conceived by Mr. Larimore, combines two major premises: indexing portfolio asset classes; and implementing the portfolio with simplicity.

The current state of the US retirement investment system, dominated by corporate and personal contribution retirement plans, essentially forces individuals into becoming investors. Many individuals delegate this function to advisors who incur high costs and are riddled with conflict-of-interest. The indexed three-fund portfolio provides investors with market returns at minimal cost and requires little time and effort to set up and maintain. An advisor is not required. Larimore provides a step-by-step guide for establishing a portfolio: first by selecting total market funds or their substitutes and determining asset allocations; then by selecting account types; and finally by implementing the portfolio by selecting the financial firm that will provide the investments. Once the three fund portfolio is established, Larimore advises that investors “stay the course” with their investment programs.

As Mr. Larimore points out, investors now have an expanded opportunity to implement a three-fund portfolio due to the wider availability of total market index funds. Multiple mutual fund families (Vanguard, Fidelity, Schwab, and TIAA for example) and exchange-traded fund providers (notably the “big three”–iShares, Vanguard, and State Street) offer investors low-cost total market funds.

Adjusting to circumstance

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Taylor Larimore

While Mr. Larimore is an advocate of total market index investing, he realizes that real life circumstances can force some adjustments to the portfolio. He examines two common situations that many investors face:

  1. Investing in a taxable account;
  2. Investing in an employer provided retirement plan.

Millions of US employees work for very small companies that do not provide employer based retirement plans. These individuals are limited to Individual Retirement Accounts for tax preferred investing and frequently devote additional investment savings to a taxable account. Investors can acquire large taxable accounts from the sale of a business, sale of residential or commercial real estate properties; receive insurance payments; receive settlements; or inherit taxable accounts.

Larimore notes that US total stock market index funds and international stock market index funds are tax efficient, with very little capital gains distribution, and, under current US tax law, high percentages of tax preferred dividend distributions. These characteristics render them suitable candidates for placement in taxable accounts.

The US total bond market index, however, holds corporate and mortgage securities that pay taxable interest. For highly taxed individuals, Larimore advises that a low-expense, high credit quality intermediate term tax-exempt bond fund can be used as the bond component of a taxable three-fund portfolio.

Employer provided plans

In the US, employer provided plans display a wide variance in expenses and investment offerings. Mr. Larimore notes that many individuals will have plans that do not include total market index funds in the investment menu.

If you face such limitations, Larimore suggests that you first look at the plan’s target date retirement funds. The 2006 Pension Protection Act sanctioned the use of target-date funds as a qualified default investment alternative in defined contribution plans, so they are a common feature of most plans.

Larimore advises that you select only a low cost target date fund, and that you carefully examine the underlying portfolio asset allocations to assure that it meets your asset allocation and fund choices. Both cautions are merited. According to the Investment Company Institute’s 2018 mutual fund factbook, the average expense ratio for target date balanced funds in 401-k plans is 0.53%. This compares to the 0.09% expense ratio that Vanguard charges for institutional target date funds. In addition many target date funds employ 15 or more actively managed funds as underlying investments (for example, check out the allocations of the American Fund Group’s 2035 Retirement Date Fund, and the Fidelity Freedom 2035 Fund.)

If the target date funds in the plan are not suitable. Larimore suggests looking for low cost index funds in the plan. He notes that an S&P 500 index fund is a common plan offering, and can be used as a substitute for a US total market index fund. He also notes that an S&P 500 Completion Index fund can be combined with an S&P 500 index fund to replicate a total market allocation.

Issues not addressed

Some additional issues involving the three fund portfolio are not addressed within the confines of this short book. These issues include how to handle multiple accounts, as well as some potential trade-offs involving replicating total market investing and simplicity in managing a portfolio.

Multiple accounts

In today’s investment markets it is common that investors will accumulate multiple investment accounts over their investment careers. An example should suffice to illustrate the situation. We will examine the investments of a young husband and wife.

In this scenario, both spouses work and participate in their employer’s 401-k retirement plans. Both husband and wife contribute to personal IRAs, in this instance Roth IRAs, and they also have a taxable account. In addition, they have a health savings account. This brings the account tally to six investment accounts. Over time, the number of accounts might easily expand to include rollover IRA accounts when the couple change jobs, as well as inherited IRAs that the pair receive from the estates of departed parents (we would now have ten investment accounts).

The couple can simplify this situation by using one investment firm for implementing the accounts they personally control. In our example, the Roth IRAs, the taxable account, the rollover IRAs, and inherited IRAs all are directly controlled by the investor. Thus, each of these accounts can hold the recommended three total market fund portfolio with little or no adjustment (perhaps substituting a tax-exempt bond fund for a total market bond fund in the taxable account).

Over time the number of accounts being managed can be further consolidated if the couple decides to roll 401-k plans to the rollover IRAs at retirement. Also the inherited IRAs must be distributed over time, and will eventually deplete.

Replicating total market investing

For an investor who adheres faithfully to total market investing, the limited options available in employer provided retirement plans can be supplemented with funds that approximate US and international total market allocations. This increases the number of funds in the portfolio, which is not quite as simple as the three fund concept.

Returning to our example, let us examine how our couple might go about replicating the total market with the limitations imposed by 401-k plan investments.

Our husband’s 401-k plan offers no total market funds. However it does offer an S&P 500 index fund and an international stock index fund, as well as an assortment of bond funds. He selects a three fund portfolio consisting of:

  1. S&P 500 index fund
  2. MSCI EAFE index fund
  3. Pimco bond fund

Wanting to approximate the total market, our husband decides to use the following funds in his Roth IRA held at Vanguard:

  1. Extended market index fund
  2. Emerging market index fund
  3. International small cap index fund
  4. US total bond index fund

The extended market index fund in combination with the S&P 500 index fund replicates the total US market. Adding the emerging markets index fund and international small cap index fund gives him a rough approximation of the total international stock market.

The wife’s 401-k plan offers only actively managed American funds. She selects three funds:

  1. Investment Company of America (large cap blend fund)
  2. EuroPacific Growth Fund (developed markets)
  3. Government Bond Fund

Wanting to approximate the total market, our wife decides to use the following funds in her Roth IRA held at Vanguard:

  1. Extended market index fund
  2. Emerging market index fund
  3. International small cap index fund
  4.  US total bond index fund

Summation

Taylor Larimore’s “Bogleheads’ Guide to the Three-Fund Portfolio” offers both novice and sophisticated investors a simple portfolio that provides the investor with market returns at minimal cost. This formula is hard to beat.

Further reading

Additional sources about three-fund portfolios:

About

Barry Barnitz, administrator of both the Bogleheads® wiki and of Financial Page, a Bogleheads® blog

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