This is portfolio management simplified.
When constructing a portfolio to achieve your investment goals and generate returns, sometimes less is more. A three-fund portfolio that includes U.S. equities, international equities and bonds could be all you need. Tony Drake, CEO and founder of Drake & Associates in Waukesha, Wisconsin, says this strategy is often called the “lazy portfolio” because of its simplicity. “The concept is based on boiling down to three inverse asset classes that are very different,” he says. “The theory is that when one goes up, another will go down.” Drake adds that while it’s an ultra-simplistic approach, there is a layer of complexity when it comes to choosing the three funds to include. Like any other investment plan, there are advantages and disadvantages to consider. Here are seven of the most important rules to keep in mind for building a three-fund portfolio.
The three-fund strategy isn’t for everyone.
Building an investment portfolio with just three funds may not work for every investment style. “This method is best for passive investors who want to create a ‘set-and-forget’ strategy of staying invested without any maintenance,” says Peter Brunton, chief investment officer of Strategic Wealth Partners. That may be music to your ears if you prefer a passive investment strategy. On the other hand, investing with just three mutual funds may be a mismatch if you’d like to take a more hands-on approach to portfolio management. “A three-fund portfolio doesn’t allow for active asset allocation decisions,” Brunton says. That could limit your portfolio’s return potential, which is something to weigh in the balance.
Check the timing.
Time in the market is more important than trying to time the market. When considering a three-fund portfolio approach, the amount of time you have to invest and grow wealth matters. Drake says this method is more suitable for a longer investing horizon. “It’s much more appropriate for someone with a good appetite for risk; for example, a younger investor who isn’t troubled by the swings of the market.” He adds that, on the other hand, someone who’s getting closer to retirement may find this approach elevates risk at the wrong time. That could be particularly troublesome when stock market volatility takes hold, as older investors may not have as much time to recover from wide pricing swings.
Diversification still matters.
The ideal three-fund portfolio emphasizes broad diversification, says Christopher Rogers, a partner with Capital Fund Law Group. Index funds can offer that, often at lower investment costs compared with other types of mutual funds. “The goal is to find the index funds that provide that broad diversification, such as a total stock market fund for your stock index and a total bond market fund for your bond fund index,” Rogers says. When a portfolio featuring three funds lacks diversification, the potential result can be increased risk and/or diminished returns. In choosing which funds to include in a three-fund strategy, it’s important to look at the underlying holdings and follow this tried-and-true investing rule: Know what you own.
Be thorough in researching funds.
When deciding which funds to include in your three-fund strategy, cost may be one of your top considerations. The higher the expense ratio, the more of your returns you’re handing back in fees. But it’s important to avoid tunnel vision where fees are concerned. “Do not base your decisions solely on cost,” says Jen Farrington, an investment advisor representative with Cutter Financial Group in Falmouth, Massachusetts. “Make sure to look at the cost, the diversification and the historical performance of the fund.” In other words, cost is just one piece of the puzzle. Even though a fund may have a low expense ratio, it’s important to consider the returns that fund may produce for you over time.
But don’t get too hung up on fund selection.
While it’s important to ensure that a three-fund portfolio is properly diversified, one mistake you don’t want to make is getting overwhelmed by which funds to choose. “Don’t stress over the selection of this fund or that fund,” says David Kuzma, a financial advisor at McLean Wealth Partners. “The goal is to have an allocation that aligns with your risk tolerance.” Remember, all you need is a fund that offers exposure to the total U.S. stock market, the total international market and the total bond market. One way to keep fund selection simple is to stick with index funds from the same brokerage. Vanguard, for instance, makes it easy to build a three-fund portfolio with minimal expense ratios.
Pay attention to percentages.
Even though your portfolio may have just three mutual funds, you can’t overlook how your investment dollars are allocated to each one. When choosing allocations, start with bonds first, says Jacob Sadler, associate financial advisor at Woodstone Financial. “This exercise often necessitates consideration of an investor’s planning goals and income needs.” Once you’ve got your bond allocation nailed down, you can then focus on divvying up the remaining room in your portfolio between U.S. and international investments. Sadler says asset location also matters, and you should consider placing investments strategically to minimize tax liability on gains. Bonds, for example, may be better off in your 401(k), while dividend-paying stocks may be a better fit for a Roth individual retirement account.
Don’t forget to rebalance.
One of the biggest — and most common — mistakes associated with a three-fund investing approach is failing to rebalance assets. “If you intend to have a 60/30/10 split between the index funds to keep your portfolio diversified, you still have to rebalance regularly to keep that ratio,” Farrington says. “For example, if the U.S. stock index funds perform exceptionally well, it may now contain more than 30% of your total portfolio assets.” Failing to rebalance regularly could expose you to more risk than you’re comfortable taking on. Taking time to review your allocations on a recurring basis, whether it’s quarterly, biannually or yearly, can help ensure that your portfolio stays aligned with your goals and risk tolerance.
Seven rules for building a three-fund portfolio:
— The three-fund strategy isn’t for everyone.
— Check the timing.
— Diversification still matters.
— Be thorough in researching funds.
— But don’t get too hung up on fund selection.
— Pay attention to percentages.
— Don’t forget to rebalance.
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