A beginners Guide to the 3-fund portfolio

Background

This is a book that I am taking from the bogle heads forum, which has become closely linked to the FIRE crowd. They don’t expressly cater to the idea of early retirement like we do, but their goals and ideas align closely enough that we of the FIRE community can gain a ton of value from the ideas and processes they use.

If you hang around other FIRE websites or forums, or hangout on the financial independence subreddit, chances are you already know the 3 fund portfolio or have at least heard about it even if you don’t know what exactly it is. Plenty of people swear by it, while other’s aren’t so warm and fuzzy.

Often when someone asks a FIRE-minded friend how to get started into investing the first piece of advice they will receive is “invest it all in VTSAX!” Let’s do a quick analysis of this advice to see where it holds merit and where it is lacking.

The Basics of VTSAX

First of all, VTSAX is a low cost ETF, with an expense ratio of 0.04%. This is good, considering the average expense ratio of a mutual fund is somewhere between 0.5 and 1%. VTSAX is well below average in that regard, so the owners of the fund aren’t bleeding us into the red by taking all of our profits and growth in the stock market and paying it to themselves. We like when our fund managers aren’t greedy.

What actually is VTSAX though? VTSAX full name is Vanguard Total Stock Market Index Fund, meaning that when the fund receives money from investors, it splits that money up and invests it into every stock that is publicly traded on the market, in proportion to the size/value of the company. (This is an overly simplified view but it gets the point across)
Compared to picking individual stocks, this is generally a much better strategy. It diversifies the risk of the investor by not tying his or her success to the success of any one individual company. Instead that risk is spread out across all companies so that when the market does well as a whole the investor wins, and when the market as a whole does poorly, so to does the investor. (HINT: in the long run the stock market always goes up)

VTSAX hasn’t been around forever, but the S&P500 has been for a good while, and closely tracks the total market fund (Correlation of ~0.99) so we will take a look at that. First, lets look at annual return.

As you can see, the solid majority of years yield a positive return, so we’re looking good there. Clearly noticeable is the great depression in the 1930’s, and more recently, the dot com bust in the early 2000’s, as well as the great recession, with the largest drop since the great depression in 2008. Those events really sucked, but when you look at the big picture, it’s mostly positive. As of the writing of this post, the average annual return since 1926 is 11.9%, but as an assumption, a rate of 9 or 10% not accounting inflation is a safer and more reasonable bet. So what does that look like when compounding?

Well, here you can see that if you put a dollar into the market in 1926, it would now be worth roughly $9,206, for a 920,600% rate of return. Pretty good huh? To be fair, a dollar in 1926 was worth $14.49 of today’s dollars due to inflation, which reduces our real rate of return by a good bit. It’s very clear though that investing in the market would give you much better results than, for example, a savings account that matches inflation. On the above graph it’s a bit hard to see any growth before 1980 due to the exponential growth, so just for fun, lets look at pre-1980 returns.

See? The gains were there the whole time, they were just dwarfed by the exponential effect on money that compounding returns has! These crazy gains are why a total market fund (or S&P500 fund) typically makes up the lion’s share of a 3 fund portfolio.

A Counter to Why You Shouldn’t Invest Solely in VTSAX

However, even though a person investing in VTSAX is way ahead of the average investor, they still haven’t truly “diversified.” Some would argue that investing in a total market fund is enough diversification for any one individual, after all, they’ve invested in every single stock the New York Stock Exchange has to offer. The world is so much bigger than the US stock market though!

Enter the Vanguard Total Bond Market Fund (VBTLX) and the Vanguard Total International Stock Index Fund (VTIAX). These are the cousins of our VTSAX total market fund. The VBTLX helps to diversify out of just stocks and into bonds, another wonderful investment vehicle, and one that is much less volatile than stock. The VBTLX does the same thing that VTSAX does for US stocks, but instead for the US investment grade bond market.

The VTIAX also mirrors VTSAX, but for stock in international companies rather than US companies. Both add diversity to your investing so that if one market isn’t doing well, the others can make up for it.

Finding Balance Between Stocks and Bonds both International and Domestic

Typically, stocks and bonds are inversely correlated (though that isn’t always the case) and balance each other out well. In the same way, if the US companies aren’t doing well, one of two things are probably happening. Either businesses in other countries are doing really well and taking market share, in which case you’ll be happy you invested in VTIAX, or the entire world is experiencing a recession/depression, at which point you’ll be happy for the slow steady returns of VBTLX.

That pretty much covers the basics of the 3 funds in this portfolio. I will be writing a follow up to this post talking about risk tolerance and how to choose allocations for these 3 funds. I know this article had a heavy focus on VTSAX, which was intentional as I am biased toward the high risk high reward route with my personal time horizon. If it interests readers, I will do a more in depth analysis of VTIAX and VBTLX in a subsequent post as well. Let me know if you would find this valuable in the comments!

*This article does not constitute investment advice, it purely reflects my personal opinions. I am not a CFP, invest at your own risk.

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