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

hey everybody welcome back to the financial freedom show my name is rob berger in today's episode we're going to take a deep dive on what's called the three fund portfolio it's a simple low-cost yet powerful and i would even say sophisticated way to invest i think it should represent the core of anyone's portfolio i can tell you 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 if you get to grow your assets and you have more and more money all these advisors want to they want to get all fancy on us and slice and dice your portfolio into 15 or 20 or 50 different funds and it's a bunch of nonsense a three fund portfolio gives us everything we need to invest our money whether we're investing a thousand bucks a hundred thousand a million ten million it doesn't matter so here's 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 we're going to actually look at the numbers and then we're going to look at the historical returns how has this three fund portfolio performed over the last few few decades so that's the first part then we're going to look at actually how to create it we're going to look specifically at what how much do we allocate to each of the three funds that we're going to talk about that make up the three fund portfolio that's going to be the first thing and the second thing is what funds should we use i mean should we use fidelity vanguard you know what what blackrock what funds should we use to build this portfolio we're going to talk about that then i'm going to actually walk through building it for you i mean it couldn't get any easier i'm going to build it for you in m1 finance it's one of the i guess newer online brokers if i were starting today from scratch i would use m1 finance without question 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 in m1 finance you don't actually have to open an account at vanguard and particularly for beginners there's good reasons frankly to favor m1 finance over some of the more traditional brokers we're going to talk about that then i told you this was a deep dive then we're going to look at ways you can actually supercharge the three fund portfolio add a few more things to it that i think give you a good chance of increasing your returns over the long term without significantly increasing volatility okay so with that let's get right to it and the start is what is a three-fund portfolio it's really simple it's a portfolio in which we just have three could be mutual funds or etfs one covers u.s stocks that's stocks of publicly traded companies that are headquartered in the united states right so think amazon and apple and believe it or not a lot of companies you and i have never heard of so that's that's bucket one we could call it right or mutual fund number one then we want one that covers all companies headquartered outside of the united states so some sort of global or international fund that's number two and the third one is simply a bond fund and here you can get all fancy with it i mean there are emerging market bond funds international bond funds but folks in the united states i think it's just best to stick with some sort of u.s total market bond fund you'll invest in some government bonds some corporate bonds but you can do it all within a single fund and that's it those three funds and we're done it's really that simple now we do use index funds and that's important because index funds well for two reasons they're a lot less expensive than actively managed funds and they they outperform so and usually over the long term even compared to really good actively managed funds index funds tend to outperform the actively managed funds by the cost right the difference in the fees that's usually roughly the difference and you know when you're paying five or ten basis points for an index fund and you're paying one percent or more for an actively managed fund that difference it may seem small but if you've watched this channel long enough you know that it'll result in a loss of hundreds of thousands and even millions of dollars over the long term all right so that's it that's the basic refund portfolio i wish i could make it sound fancier and more complicated but it just isn't and yet it can actually give you an incredibly diverse portfolio and one that has excellent returns so let's sort of dive into that now how should we think about the diversity of a three punt fund portfolio i'm going to actually turn on my monitor here for you we are looking at one of the funds you might use we're going to look at a lot of different ones here in a minute but one of the funds you might use to build three fund portfolio this is the vanguard total stock market index fund and let me actually show you how i got here i know this the the ticker which is right here vtsax i know it because i own shares of this fund so you can just google the ticker and you're going to get a nice snapshot of the fund and here's the link to the vanguard where we were just at and we're back there so that's how i got to this screen and if we want to know one question might be well it's just one fund i mean how many stocks can it really invest in well we can actually figure that out if we just go to the portfolio tab and we scroll down well there it is number of stocks i mean they couldn't make it easier they put it right there 3640 companies so in just one fund you invest in over 3 600 companies and if we want to look at fees and this is just i think extraordinary look at the cost it's four basis points you get you can invest in over 3 600 funds for just .04 it's extraordinary now so that's an example of one of the funds right that you could invest in in a three-fund portfolio with over 3 600 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 yep here it is so we'll go to the vanguard page again and so this could be the second fund in our example right and it's gonna cover the international stocks and if we go to the portfolio we'll see this is going to have even more yep seven thousands right here 7 361 stocks are in this fund and the fees just 11 basis points right here just extraordinary uh we could do the bonds just to sort of close this out vbtlx i own shares of this as well just full disclosure and go to the total bond market again we're looking at vanguard and if we pop over to the portfolio by the way i can tell you now this is going to have even more because a bond fund there are a lot of bonds out there so let's see yeah 10 025 bonds and if we go to the fees could be a tad higher no five basis points so uh i mean that's i think pretty extraordinary right you've got three funds think about it we've got over 10 000 stocks and over 10 000 bonds with just three funds that cost four basis points five basis points and i think it was what 11 basis points so here's the thing to keep in mind you cannot determine the diversity of a portfolio by simply looking at the number of funds i've seen advisors and it just it angers me anyway they'll put a client in like 20 different funds they'll charge the client one one and a half percent the average expense ratio of these funds is one one and a half percent and they're no more and often 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 event 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 to rebalance a portfolio with 20 funds actually m1 finance makes that easy that's another story we'll look at it but still with just three funds it's about as easy as it it can get it's low cost it's it's i think just an excellent way to build if not your entire portfolio at least the core of your portfolio now having said all of that the big question is well what are the returns so let's go back to the screen here and i'm going to pop over here to what's called the portfolio visualizer it's a free tool and i use it a lot and they actually make it easy to see the historical returns of a three fund portfolio you can actually compare three three different portfolios and we're going to use that feature in a minute but to start with if you click this button you can customize this you can pick whatever asset class you want and what percentage and so forth and so on but there's also some sort of uh pre uh portfolios that they sort of uh pre-populated and you can just select from them right and one of them is the bogle heads three fund portfolio if you're not familiar with the bogle heads it's named after jack bogle the founder of vanguard they have an incredible forum it's just an incredible group of people that they'll they help out new investors but you can google bogleheads and you just get a ton of wonderful information i'm a huge fan in any event if we just click that it pre-populates not only the asset classes and there they are right we've already talked about them u.s stocks global stocks total u.s bonds and they've populated a percentage we'll talk about that in a minute but this is sort of the standard three fund portfolio 50 in u.s stocks 30 in global stocks 20 in bonds now we're going to look at this from 1972 to to to the current year 2021. that's as far back as the data goes but it's it's plenty long enough but keep that date in mind we're going to come back to in a minute we're going to assume an initial 10 000 investment and we're not going to assume any additional investments so how did this portfolio do click the analyze portfolio button first thing i want to point out is notice this the results don't begin until january nineteen eighty even though if we come back up here we set it to begin in 1972. what's going on well you can see the explanation here one of the asset classes we were using total u.s bond market it's this one right here right they don't have data going back to 1972. they only have data going back to january 1987 and so sometimes you might want to have a longer period the tool adjusts according to the data that it has for our purposes that's fine we're still looking at over 30 years and we can see if 10 000 investment would grow to over 168 grand and have a this stands for compound annual growth rate of 8.64 if we think about it that kind of makes sense stocks over the long term generally return about 10 but we also have bonds in this portfolio 20 allocated to bonds to to dampen a little bit of the volatility so that we can sleep at night and so that's our compound annual growth rate excellent returns uh i would i can't imagine any active manager with the same asset allocation who has outperformed that return over the last 30 years now remember this number 8.64 i want to come up here and make a slight change to 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 that i know of does that we're putting some money away in our 401k every month maybe an ira maybe taxable accounts well we can model that with this tool so let's contribute an amount we're going to say we're going to contribute we'll call it 500 bucks a month obviously you can use this tool and change the assumptions all you'd like we'll adjust the contributions for inflation so that's good and we'll make it monthly instead of annually and we're rebalancing the portfolio annually that's good remember our compound annual growth rate was 8.64 now what watch what happens it jumps to 16.12 holy cow that's huge and look at our balance it goes you know it was up to like 168 grand you know we invest 500 bucks a month and it jumps to 1.6 million it's like so clearly this calculator is broken it's not broken the calculator is working just fine all right back to the calculator first it shows us the power of compounding even over relatively small amounts of money 500 bucks a month and the reason the compound annual growth rate changes is because when you start to invest a stream of money on say a monthly basis you're investing in good markets in bad markets we can look down here there were different crashes right this was in the 0-809 period this was the tech bubble when it burst so you're investing in really bad times as well as good times and that's going to affect your return we all know it's best to invest when the market is down i think for most of us we just dollar cost average and that affects the compound annual growth rate of a portfolio so the the but the real takeaway is three fund portfolio has done exceptionally well over the last in this case more than three decades we could go back further there are other ways to model uh the three fund portfolio and it does very very well so that's how it's performed over the last 30 plus years now let's sort of transition into that's great rob how do i actually create one and i want to begin with the asset allocation so let's actually go back to the the portfolio visualizer remember we pre-formatted this or pre-programmed it if you will just by using the the bogel heads three fund portfolio and it automatically filled in these percentages the biggest question and this is whether true whether you use a three fund portfolio or something else the most important question we're going to ask as investors is our asset allocation between stocks and bonds that's going to be more important than international versus domestic small cap versus large cap those are important questions too but they are 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 some different assumptions let's first imagine a 90 10 remember this is 80 20. the 50 and the 30 are both for stocks that adds to 80. the 20 is bonds so let's do a 90 10 so we could do that by oh we'll say 55 here 35 here and then we'll just lower this to 10. all right that's our 9010 portfolio and then we can go the other way for a 70 30 portfolio so this will go to 45 right i'm just subtracting 5 from the 50 here this will go to 25 and then we'll bump this to 30 and yeah they all equal 100 good and let's compare the portfolios and again we're looking from 87 to 2021 we have our different portfolios here right and we can look at the returns i'll try to keep this on as much on one screen as i can actually just pop it up here we know portfolio one was the one we started with portfolio two was the 90 10 portfolio so our returns went up our compound annual growth rate bumped it wasn't a huge difference though that actually may surprise people uh that are sort of big and 100 stocks or 90 stocks yeah the returns are higher but not dramatically so and um you know the standard deviation really pops here goes from 12.13 to 13.65 if you're not familiar you could just look at that as a measure of volatility the higher uh the number the more volatile and and when you look at the actual worst year max drawdown um 49 versus 43 call it 44 percent that's pretty significant now if we go down to the 70 30 uh of course the returns are lower and the compound annual growth rate drops below 16 still not a huge difference and yet the standard deviation look at this it drops from 12 or 13 all the way down to about 10 and a half 10.65 that's a pretty significant drop so i show you this so that you can figure out what's best for you i will tell you when i was let me come back to the screen here when i was younger and didn't have as much gray hair i was 90 10 and it served me just well would my life have changed if i were 80 20 no probably not it probably wouldn't have changed much if i were a 70 30 portfolio which is roughly i'm probably more like 80 20 right now moving towards 70 30 but of course i'm probably older than most people watching 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 views but at the end of the day even then you have to make that decision i personally think all of these portfolios that i've shown you and let's go back to the screen are perfectly reasonable choices i would tend to be closer to the 80 20 or 90 10 portfolio but that doesn't make it right that just makes it right for me but this gives you an idea of the data and the volatility and the returns do are we guaranteed for all of this to repeat itself over the next 30 years of course not we all know that that's not true but i think it's the best data we have it's drawn over a long period of time and it gives you a sense of what to expect so i think 80 20 is a sweet spot but but again you know you have to make this decision for yourself but there is the data to make it now having said all that the next big question is what funds do we use well if you're investing in a 401k your choice of funds are determined by your employer and whoever they have managing your funds let me say one thing about that so far for the u.s stocks we've looked at a total stock market index fund i guess it's possible in your 401k you don't have that option but you do have an s p 500 index fund it's a perfectly reasonable choice yes it doesn't have you know 3 600 companies in it it has around 500 but it's still incredibly diverse and frankly the long-term returns and volatility of an s p 500 index fund are very very similar to a total u.s stock market fund so don't worry about that decision you obviously have to make it if you're outside of a 401k and you can pick either or you're inside a 401k and they have both options don't lose sleep over the decision i personally would go with a total stock market fund because it includes some mid cap and small cap but it's it's not frankly probably going to make much of a difference to your portfolio over the long term if you're outside of 401k now you have some choices to make you go with vanguard you go with someone else here's what i'm going to do i'm going to leave a link below the video to the article i've written on this uh very topic in fact i'll actually show it to you on my ipad here believe it or not i take some notes before these videos and you can see some of the the options that i'm going to show you that you'll see in the article here's uh vanguard both mutual funds and their etfs uh here's fidelity they have both they're zero funds as well as they're sort of i could call them more standard funds by the way their standard funds like fidelity total market index follows a well-known index their zero funds actually follow a fidelity proprietary index it's one of the reasons they don't charge expense ratios in any event maybe that's for another video uh charles schwab i've got the thrift savings plan i know a lot of you uh work for the government uh you're in the military thank you for your service you work at the postal post office thank you for your service thrift savings plan is here t row price so i give you specific uh funds with the tickers with the ticker symbols so that you can build out a three fund portfolio 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 all right now having said that i mentioned m1 finance and i want to actually show you how to build the the three fund portfolio inside of m1 finance and then i'm going to talk to you about why i like m1 finance so much and frankly vanguard if you're listening please add some of these tools to to vanguard it would really make my day and it would make our lives as investors a heck of a lot easier all right so let's head over to the computer again and we're in what we were in my m1 finance account let me log back in so you'll notice i have a big fat zero i was using this for a while to test it out i actually love it moved my inves the small amount of investments i had in there back to vanguard what i'm actually going to do is be moving over to here about twenty thousand dollars which which represents uh my investments in the money that i've saved from credit card rewards i save we save and invest all of our credit card rewards we've done that now i think we're in year three and we're up to 20 grand and so i'll have more about that in a future video but here's what i want to do um i'm going to actually click over to my joint account so my my wife can be involved and so creating any portfolio in m1 finance is very easy but let's quickly create a three fund portfolio so the first thing you want to do is come over to this research tab and we can look at my pies that's what they call them you can think of each pie as a portfolio or even your own mutual fund you can see i've got a four five and six fund portfolio i'm going to show you those in a minute and i'm going to give you links to all of these in the notes below the video but let's create a new pie so we'll come over here and we have to search for 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 basket and then i'm going to search for i know the ticker on this but let's assume i didn't this is the vanguard total international stock we can actually search by name total international uh here it is comes right up vxus add that to our basket and then the last one i'll just use the the um the ticker bnd it's their total bond fund add that to the basket and we can see down here they're all the three funds we're going to add them oops there we go and here they are now you'll notice that what they've done they've pre-filled the percentages uh for us we're going to change that one thing to keep in mind and this is actually like a beautiful beautiful feature of m1 finance one of the reasons i like it if you invest whatever 25 bucks 100 bucks a million bucks doesn't matter into this pie in your account m1 finance will automatically divide it up by whatever percentages you set the other thing they'll do is let's imagine you do that and a year later markets have gone up they've gone down and your allocation is sort of out of whack now whatever you set it at it's changed my stocks have 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 among the different investments they look at which investments have deviated from your plan and they invest your new money accordingly to start to move your your portfolio back into alignment with your initial asset allocation that is a beautiful thing it's just one of the the other features that i love about m1 finance there's one more one as it come when it comes to rebalancing that i'll get to in a minute but let's first let's get these target percentages correct so if we edit it uh we get this nice feature and we can change this so we're going to follow the boglehead standard approach which is an 80 20 with 50 in u.s stocks and then 30 in international stocks and we're going to give it a name let's call it the three fund portfolio and we'll save it and we're done it's that simple now um as i said i will give you a link to this uh a portfolio you if you're an existing m1 a finance uh uh account holder you can use this in your current account if you're new uh you can add this as part of creating an account or you can just check out these portfolios even if you're investing somewhere else just to get an idea of of how i've built them again i'm not suggesting these are right for everyone you have to make your own choice as to what's best for you but i think these are great core portfolios or could even represent the entire portfolio and one thing i'll mention let's go back to the pies let me open this one back up you don't see it here because i haven't added this to my portfolio or added money but the the one 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 for you you know there's no getting the spreadsheet out or the paper and the pencil and figuring out okay i need to sell how many shares of this fund to get over to that fund you just click a button now if it's in a taxable account you want to make sure you're aware of the tax consequences of rebalancing in an ira for example of course there aren't any and so again this is where i hope vanguard watches this video maybe i'll shoot it over to my friends at vanguard i mean why can't vanguard have this one-click rebalancing it's not that complicated um yeah if i were starting from scratch that's another reason why i would use m1 finance okay now i mentioned at the beginning of the video we were going to look at how to supercharge your um uh your three fund portfolio this is not necessary i think a three-fund portfolio is fantastic you could just go with that but i i tend to use a six-fund portfolio again in m1 finance it'd be incredibly easy but even in a traditional broker it's not that hard to manage just six mutual funds but i think you could add up to three different asset classes to a three fund portfolio to sort of as i say you know supercharge the returns so let's look at those we're going to go back to m1 finance and look at these other pies let's start with the for fund portfolio what i add you can see it down here is i add small cap value and i add added 10 so i drop my total u.s market fund from 50 to 40 and i add the 10 percent to small cap value what we know from history is that small cap value while it's a little more volatile uh it it's expected returns are higher uh than say an s p 500 now not always the last few years large growth companies have just been on fire as we know but long term small cap value tends to do really well you know you could go with just a small cap that's not tilted towards value i think that's a reasonable choice as well in this pie though and i'm still getting used to by the way calling these pies in this pie uh i use small cap value and what i'm going to do in the article for this podcast is i've actually done using the portfolio visualizer some returns analysis and i'll include images of all that in the article which you can check out so that's the four fund i'll go back to the pies here let's open up five uh fund what i do here i keep the ten the ten percent in small cap you see that here but i add ten percent to emerging markets and to do that i lower the international stock uh from 30 to 20. and emerging markets it's kind of the same argument as small cap value they're very volatile but they have high expected returns and remember our concern isn't the volatility of any one investment or asset class our concern is the volatility of the portfolio as a whole and what's beautiful about this sort of sort of low-cost asset allocation investing is that you can add a very volatile asset class to a portfolio without increasing significantly the volatility of the portfolio as a whole because it's just one ingredient in a much bigger portfolio so if i were going to do five funds i'd add small cap value and emerging markets again i'll leave a link to this portfolio uh below the video and then finally the last one is the six fund and what do i add i add reits right here it's v and q is the etf version and to do that i lower the total stock market fund again from 40 to 30. one thing i would caution you is that you don't want to own reits in a taxable account it's it's brutal on taxes they have to distribute 90 of their their uh profit as income uh to maintain their their the benefits that the irs gives reits and it's typically taxed as ordinary income so you don't only want to use this in a tax deferred ira type of account if you're investing in a taxable account i wouldn't go with this six fund portfolio i would stick with a five fund portfolio or i would simply have my real estate allocation in a different account you know either the 401k if i have one or an ira but you don't want to hold reits in a taxable account well there you go i know it's a deep dive but i think it's important that we not only understand what a three-fund portfolio is but we understand you know is it diversified what are the expected returns how do we create one what are the asset allocation options that we have you know part of that is taking the mystery and fear out of investing this isn't complicated uh but you know there's some things to know once you know it it's kind of easy you know when someone says hey my small cap value fund did blah blah blah well you know what a small cap value fund is so that's helpful in any event there you go if you have any questions leave them in the comments below i'll do my best to help you out again i'll have a ton of links below as well and if you haven't subscribed to the video and you've made it this far i mean why not subscribe now what do you got to lose hey thanks for watching and until next time remember the best thing money can buy is financial freedom

Channel: Rob Berger

Views: 84,455

Rating: 4.9599848 out of 5

Keywords: 3 fund portfolio, investing for beginners, three fund portfolio, boglehead 3 fund portfolio, how to invest, vanguard index funds for beginners, vanguard index funds, bogleheads 3 fund, lazy 3 fund portfolio, index fund investing, passive investing, stock market for beginners, how to invest in stocks for beginners, vanguard index funds s&p 500, m1 finance, 3-fund portfolio m1 finance, 3 fund portfolio vanguard, 3 fund portfolio fidelity, 3 fund etf portfolio, m1finance

Id: kmw8OpGp2rM

Length: 31min 15sec (1875 seconds)

Published: Tue Feb 23 2021