Financially reviewed by Patrick Flood, CFA.
The Bogleheads 3 Fund Portfolio is arguably the most popular lazy portfolio out there. Here we’ll investigate its components, historical performance, and the best ETF’s to use in its implementation.
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What is the Bogleheads 3 Fund Portfolio?
The Bogleheads 3 Fund Portfolio is arguably the most popular lazy portfolio. “Bogleheads” are followers of the advice and path of the famous Jack Bogle, founder of Vanguard and considered the father of index investing. I am one. The Bogleheads Forum houses an exchange of knowledge surrounding Bogle’s principles.
The Bogleheads 3 Fund Portfolio, as the name implies, is a simple portfolio comprised of 3 broad asset classes – usually a U.S total stock market index fund, a total international stock market index fund, and a total bond market index fund.
The Bogleheads 3 Fund Portfolio draws on the idea of portfolio diversification’s ability to reduce volatility and drawdowns, protect against black swan events, and maximize risk-adjusted return. Holding multiple uncorrelated assets invariably reduces risk and can result in higher returns – and almost always higher risk-adjusted returns – than holding one asset in isolation.
Interestingly, the Bogleheads 3 Fund Portfolio does not have a specific one-size-fits-all prescription for asset allocation. The investor is encouraged to choose their own based on time horizon and tolerance for risk. Assuming a retirement age of 60, my general rule of thumb is to use [age-20] for bond allocation, obviously titrating up or down based on risk tolerance. Vanguard has a useful tool here to help you choose. You can also view how different allocations have performed historically.
Given that, for the sake of simplicity in this post, let’s assume a starting age of 20 and a retirement age of 60, yielding an average investor age of 40. Based on that, a one-size-fits-most 80/20 allocation for the Bogleheads 3 Fund Portfolio is:
- 60% U.S. Stocks
- 20% International Stocks
- 20% U.S. Bonds
Why Index Funds?
Bogle advocated for simply “buying the whole haystack” instead of trying to find the needle. Consider these facts:
- The evidence has shown that even most professional investors can’t pick winners that beat the market over 10+ years, much less the average retail investor like you and me.
- On the 50th birthday of the S&P 500 index, only 86 of the original 500 companies remained.
- Blindfolded monkeys randomly throwing darts for stock picks have beaten top hedge fund managers not just once, but consistently.
- Most stocks underperform the market; only a select few drive massive returns. Specifically, for U.S. stocks from 1926 through 2017, in terms of lifetime dollar wealth creation, only 4% of stocks accounted for the net gain above T Bills. Looking at global stock returns from 1990 through 2018, only 1.3% of stocks accounted for the positive wealth creation in excess of T Bills.
In short, we should reliably expect to see the empirical results we’ve observed historically: that stock picking strategies, especially those that are poorly diversified, tend to underperform the market.
Even sector bets are usually not a prudent move, as they’re just stock picking lite. Betting on sectors increases uncompensated risk – additional risk without an increase in expected return. In doing so, investors increase their chances of underperforming the market. Just like with individual stocks, some sectors will outperform and some will underperform the market. How do we know which ones will do which? And during what time periods? What about different economic cycles? Tech has had a huge run recently. Will it continue? In short, no one knows. Diversification seems to be the only free lunch with investing.
This is why broad index funds like the S&P 500 and total stock market are recommended so often. Specifically, using total market index funds, one can be fully diversified across every sector and market cap size, in this case both domestically and abroad. You can brag to your friends that you own over 10,000 stocks in your portfolio. You get exposure to the success of any sector and any stock at any given time in a market index fund, while eliminating sector risk and single company risk. Index funds are also self-cleansing in that growing companies rise within the fund and bad companies drop off.
Bogle suggested the “majesty of simplicity.” The simplicity of the 3 Fund Portfolio is underrated. This simplicity in the use of total market index funds allows investors to not have to worry about choosing the correct asset styles and cap sizes, much less the correct sectors and individual stocks.
Buying the market guarantees market returns. Using narrower funds with the goal of market outperformance (usually as a result of recency bias and performance chasing) creates complexity and the potential for market underperformance and subsequent uncertainty, dissonance, and tracking error regret, especially for novice investors. This can lead to abandoning one’s strategy altogether, usually at precisely the worst time. It is imperative that investors have strong conviction in their strategy in order to stay the course.
Why International Stocks?
At global market weights, U.S. stocks only comprise about half of the global stock market. International stocks don’t move in perfect lockstep with U.S. stocks, offering a diversification benefit. If U.S. stocks are declining, international stocks may be doing well, and vice versa.
If you’re reading this, chances are you’re in the U.S. You also probably overweight – or only have exposure to – U.S. stocks. This is called home country bias. The U.S. is one single country out of many in the world. By solely investing in one country’s stocks, the portfolio becomes dangerously exposed to the potential detrimental impact of that country’s political and economic risks. If you are employed in the U.S., it’s likely that your human capital is highly correlated with the latter. Holding stocks globally diversifies these risks and thus mitigates their potential impact.
No single country’s stock market consistently outperforms all the others in the world. If one did, that outperformance would also lead to relative overvaluation and a subsequent reversal. Meb Faber found that if you look at the past 70 years, the U.S. stock market has outperformed foreign stocks by 1% per year, but all of that outperformance has come after 2009.
Excluding stocks outside the U.S. means you’re missing out on leading companies that happen to be based elsewhere. Similarly, there have been periods where a global portfolio outperformed a U.S. portfolio. During the period 1970 to 2008, an equity portfolio of 80% U.S. stocks and 20% international stocks had higher general and risk-adjusted returns than a 100% U.S. stock portfolio. Specifically, international stocks outperformed the U.S. in the years 1986-1988, 1993, 1999, 2002-2007, 2012, and 2017.
Emerging Markets and international small cap stocks have crushed the U.S. market historically, for example, as they’re considered riskier, and investors are compensated for that greater risk. And this is just talking about performance. The volatility and risk reduction benefits are another conversation entirely, which is of huge significance for a retiree.
Notice how U.S. or international outperformance tends to be cyclical:
If I were writing this in 2010 (or 1990, or 1980), we’d be talking about how a global portfolio beat a U.S. portfolio the previous decade. The important takeaway is that it’s impossible to know when the performance pendulum will swing and for how long, much less how those time periods would match up with your personal time horizon and retirement date.
Moreover, U.S. stocks’ outperformance on average over the past half-century or so has simply been due to increasing price multiples, not an improvement in business fundamentals. That is, U.S. companies did not generate more profit than international companies; their stocks just got more expensive. And remember what we know about expensiveness: cheap stocks have greater expected returns and expensive stocks have lower expected returns.
For U.S. investors, diversifying globally in stocks is also a way to diversify currency risk and to hedge against a weakening U.S. dollar, which has been gradually declining for decades. International stocks tend to outperform U.S. stocks during periods when the value of the U.S. dollar declines sharply, and U.S. stocks tend to outperform international stocks during periods when the value of the U.S. dollar rises. Just like with the stock market, it is impossible to predict which way a particular currency will move next.
Dalio and Bridgewater maintain that global diversification in equities is going to become increasingly important given the geopolitical climate, trade and capital dynamics, and differences in monetary policy. They suggest that it is now even less prudent to assume a preconceived bet that any single country will be the clear winner in terms of stock market returns.
In short, geographic diversification in equities has huge potential upside and little downside for investors.
Bogleheads 3 Fund Portfolio Benefits
Taylor Larimore, considered “King of the Bogleheads,” and co-author of The Bogleheads’ Guide to Investing and The Bogleheads’ Guide to the Three-Fund Portfolio, succinctly summarizes the Bogleheads 3 Fund Portfolio’s benefits as follows:
- Diversification. Over 10,000 world-wide securities.
- Contains every style and cap-size.
- Very low cost.
- Very tax-efficient.
- No manager risk.
- No style drift.
- No overlap.
- Low turnover.
- Avoids “front running.”
- Easy to rebalance.
- Never under-performs the market (less worry).
- Likely to outperform most investors.
Bogleheads 3 Fund Portfolio – Choosing Assets and ETFs
Let’s explore the selection of assets and corresponding ETFs.
For the 60% U.S. stocks position, we have several choices. You could choose to use the S&P 500 index, the total U.S. stock market, the Russell 1000 index, etc. To broadly diversify across U.S. stocks, I’m suggesting the use of a total U.S. stock market fund, to get some exposure to small- and mid-cap stocks, which have outperformed large-cap stocks historically due to the Size factor premium. Vanguard’s total U.S. stock market ETF is VTI.
Similarly, for the 20% allocation to international stocks, we can use a total international stock market fund like Vanguard’s VXUS. This ETF covers both ex-US Developed Markets and Emerging Markets at their global market weights.
For bonds, the obvious and popular choice is a total U.S. bond market fund, but since we know treasury bonds are superior to corporate bonds and since a total bond market fund is usually about 25-30% corporate bonds, I’m suggesting intermediate treasury bonds, which should roughly match the average duration of the total U.S. treasury bond market. At the time of writing, Vanguard doesn’t offer a total U.S. treasury bond market fund, so we can use intermediate treasury bonds via VGIT.
Long-term bonds are likely too volatile – and too susceptible to interest rate risk – for older investors, and short-term bonds are too conservative for young investors at a 40% allocation, so intermediate-term bonds offer a happy medium that is suitable for most investors.
For that reason, my blanket recommendation for a one-fund, one-size-fits-most bond choice would be intermediate-term treasury bonds, which should roughly match the average maturity of the total treasury bond market.
That said, I’m actually a fan of the idea of putting the first 20% of your bond holding in long-term treasury bonds, especially if you’re a young investor with a longer investing horizon. The higher volatility of long-term bonds is better able to hedge against stocks’ downward movement. We’ll illustrate this below. You can access long-term treasury bonds via Vanguard’s VGLT. This ETF has an effective duration of about 18 years.
Investors can dial in a specific bond duration using a combination of different duration bond funds.
Why No International Bonds?
The inclusion of international bonds in diversified portfolios and target date funds is a fairly recent occurrence. Until recently, costs of international bond fund products were prohibitive for retail investors, and international assets of all kinds were viewed with skepticism until about the 1990’s. Vanguard didn’t begin including international bonds in their target date funds until 2013.
The evidence seems to show that international bonds may offer a small diversification benefit in terms of credit risk on the fixed income side due to their low correlation with both U.S. stocks and U.S. bonds, but there’s no compelling reason to think it’s any significant benefit. This potential diversification benefit is even less convincing for a portfolio that is not bond-heavy.
The infamous Larry Swedroe suggests, based on a 2014 Vanguard paper, that investing in foreign bonds may be prudent for reducing portfolio volatility if and only if the investor can do so with low fees and with currency hedging to eliminate currency risk. Without currency hedging, it’s basically FOREX trading. Luckily, Vanguard’s Total International Bond ETF (BNDX) satisfies those requirements.
Vanguard published another paper in 2018, proposing that “various local market risk factors (such as interest rates, inflation, and yield curves) have resulted in relatively low correlations of government bond yields across markets over the past 50 years, suggesting a diversification benefit to increasing the number of global markets in a fixed income allocation.” While the research is comprehensive, the tiny diversification benefit they illustrate is negligible in my opinion. Specifically, they showed that for a 60/40 portfolio during the period 1985-2013, diversifying internationally with fixed income resulted in a reduction of volatility as measured by standard deviation from 9.5 to 9.4, a reduction of 1%.
In short, there’s no good reason to consciously avoid international bonds, but there’s also no good reason to embrace them either; it’s unlikely to help your portfolio, and it’s unlikely to hurt it. Bogle suggested that “when there are multiple solutions to a problem, choose the simplest one.” Samuel Lee agrees, suggesting that utilizing international bonds appears to “be a case of diversification for the sake of diversification.”
If you still do want to incorporate international bonds, don’t worry; that’s just the Bogleheads 4 Fund Portfolio.
Bogleheads 3 Fund Portfolio Portfolio Historical Performance vs. S&P 500
The backtests below are for the period 1987-2019 showing variations of the Bogleheads 3 Fund Portfolio vs. the S&P 500. Portfolio 1 uses the prescribed total bond market. Portfolio 2 is my suggested variation using intermediate treasury bonds. Portfolio 3, particularly suitable for a younger investor or one who desires to assume slightly more risk, uses long-term treasury bonds.
As we’d expect, Portfolio 2 with treasury bonds achieves higher general and risk-adjusted returns (Sharpe), lower volatility, and smaller drawdowns than Portfolio 1 that uses the total bond market. Again, this is because corporate bonds are inherently more correlated to stocks.
Notice the much higher general and risk-adjusted returns and lower overall volatility of Portfolio 3 with long-term treasuries. It also has a smaller max drawdown. Again, this is due to their higher volatility that is better able to counteract stocks’ downward movement:
Bogleheads 3 Fund Portfolio ETF Pies for M1 Finance
Below are pies to use on M1 Finance for each of the 3 variations we’ve explored above, using an 80/20 asset allocation.
M1 Finance is a great choice of broker to implement the Bogleheads 3 Fund Portfolio because it makes regular rebalancing seamless and easy, has zero transaction fees, allows fractional shares, and incorporates dynamic rebalancing for new deposits. I wrote a comprehensive review of M1 Finance here.
Traditional – Total Bond Market
Using entirely low-cost Vanguard funds and the original prescription of a total bond market fund, we can construct an 80/20 allocation of the Bogleheads 3 Fund Portfolio pie like this:
- VTI – 60%
- VXUS – 20%
- BND – 20%
You can add the this pie to your portfolio on M1 Finance by clicking this link and then clicking “Save to my account.”
Intermediate Term Treasury Bonds
Using intermediate-term treasury bonds, the Bogleheads 3 Fund Portfolio becomes:
- VTI – 60%
- VXUS – 20%
- VGIT – 20%
You can add this pie to your portfolio on M1 Finance by clicking this link and then clicking “Save to my account.”
Long Term Treasury Bonds
My preferred version is this one with long-term treasury bonds:
- VTI – 60%
- VXUS – 20%
- VGLT – 20%
You can add this pie to your portfolio on M1 Finance by clicking this link and then clicking “Save to my account.”
Bogleheads 3 Fund Portfolio with Fidelity Mutual Funds
To construct the Bogleheads 3 Fund Portfolio using Fidelity mutual funds, you can use:
- FZROX (Fidelity ZERO Total Market Index Fund) or FSKAX (Fidelity Total Market Index Fund)
- FZILX (Fidelity ZERO International Index Fund) or FTIHX (Fidelity Total International Index Fund)
- FXNAX (Fidelity U.S. Bond Index Fund)
Which 3 Fund Portfolio do you prefer? What’s your asset allocation? Let me know in the comments.
Don’t want to do all this investing stuff yourself or feel overwhelmed? Check out my flat-fee-only fiduciary friends over at Advisor.com.
Disclosure: I am long VTI and VXUS in my own portfolio.
Disclaimer: While I love diving into investing-related data and playing around with backtests, I am in no way a certified expert. I have no formal financial education. I am not a financial advisor, portfolio manager, or accountant. This is not financial advice, investing advice, or tax advice. The information on this website is for informational and recreational purposes only. Investment products discussed (ETFs, mutual funds, etc.) are for illustrative purposes only. It is not a recommendation to buy, sell, or otherwise transact in any of the products mentioned. Do your own due diligence. Past performance does not guarantee future returns. Read my lengthier disclaimer here.
Don't want to do all this investing stuff yourself or feel overwhelmed? Check out my flat-fee-only fiduciary friends over at Advisor.com.