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When it comes to investing, the simpler, the better.
Jack Bogle, the founder of Vanguard, repeated this message over and over again throughout his long career in investing. This message had particularly resonated with a man by the name of Taylor Larimore.
Mr. Larimore, a man born before the Great Depression, had his own long history with investing. After reading one of Mr. Bogle’s books, he changed his mindset around investing and eventually went on to co-author “The Bogleheads’ Guide to Investing” and “The Bogleheads’ Guide to Retirement Planning.” He also holds the title as the “King of the Bogleheads.”
In this book, Mr. Larimore walks us through the Three Fund Portfolio, a simple investment portfolio that has been shown to outperform other (more complicated) portfolios. If you are investing for the long term using a buy and hold strategy, this portfolio is considered one of the simplest ones around.
ONE KEY LESSON
At the beginning of the book, Larimore discusses some of the many lessons that he has learned about investing. There is one particular lesson that he mentions not once, but twice:
Past performance does not forecast future performance.Taylor Larimore, The Bogleheads’ Guide to the Three-Fund Portfolio
Unfortunately, we humans are not wired to think long term. It’s so easy to base our decisions on past performance, especially if it was recent (otherwise referred to as recency bias). This is why investors are so tempted to buy when they see that a stock or fund is doing well. But these high performers do not stay at the top of their game forever, resulting in the reversion to the mean.
Investors that are chasing returns will find themselves stuck in a pattern of buying high and selling low, the exact opposite of what you want when you’re looking for good investment returns.
WHY INDEX FUND INVESTING?
One word: Cost.
The investment industry is a profitable one, where commissions and fees are charged for services and products that are marketed to increase an investor’s returns.
The problem is that time and again, attempting to beat the market (active investing) over the long term is a losing game the vast majority of the time. There is no surefire way to predict the winners versus the losers. When taking into account those commissions and fees, investors end up with net lower returns.
Instead of trying to beat the market, index fund investing (passive investing) aims to simply keep up with the market. This is considered a winning strategy for the long term because the general trend is that the stock market goes up over time. Yes, there is volatility, and the stock market will go through its ups and downs. But this is normal and expected, and if you stick with your plan and ride out those downturns without panicking, you will reap the rewards.
(Click here to read the post “Active versus Passive Investing: Which Style Is Right For You?”)
THE THREE FUNDS: A CLOSER LOOK
Out of the dizzying number of stock market options an individual can choose to invest in, why only three funds?
As a quick summary, mutual funds are a collection of investments that are pooled together under one fund. An index fund is a type of mutual fund that tracks a market index, such as the S&P 500 or the total stock market.
Index funds are very low cost and easily accessible, which puts the level of control directly in the hands of anyone who chooses to invest.
So why is Larimore recommending THESE three funds in particular? Let’s take a look at each individual fund:
Vanguard Total Stock Market Index Fund- Investor or Admiral Shares (VTSMX/VTSAX): This is a broadly diversified index that currently holds over 3,500 US company stocks .
Vanguard Total Bond Market Index Fund- Investor or Admiral Shares (VBMFX/VBTLX): This is a broadly diversified index that spans over 8,500 bonds.
Vanguard Total International Stock Market Index Fund- Investor or Admiral Shares (VGTSX/VGIAX): This is the international version of VTSMX/VTSAX, representing over 1,100 international stocks.
(Note: Admiral shares historically required a higher balance, but they also come with a lower expense ratio compared to Investor shares. In 2018, Vanguard lowered the investment minimums for Admiral shares in some of their most popular funds
These are all low cost, total market index funds that are highly diversified across securities worldwide. The beauty is that you’re capturing thousands and thousands of holdings around the world in just 3 funds.
BENEFITS OF TOTAL MARKET INDEX FUNDS: HIGHLIGHTS
Larimore goes more in-depth in regards to why total market index funds are the way to go. Out of 20 benefits of total market index funds that are listed in this book, here are 5 benefits that I would like to highlight:
- No Fund Manager Risk: Active funds need managers to make decisions about their funds. Regardless of how the fund is performing, managers eventually either leave or their performance reverts to the mean. With these total market index funds, you are eliminating this risk.
- No overlap: To have true diversity in your portfolio, you want to minimize overlapping. The reason you are aiming for more diversity is so that you are reducing risk by spreading it out over many holdings. The
three fundportfolio is designed in such a way that there is no overlap.
- Above Average Return: There have been a number of studies showing that passive beats actively managed funds. This has been measured via the S&P Dow Jones SPIVA scorecard, which compares managed funds to index funds. Data from the National Association of College and University Business Officers (NACUBO) is also convincing. The managers of these college endowment portfolios are top-notch, with access to investments that aren’t available to the average individual investor. Still, they tend to underperform once you take into account inflation and costs.
- Low Cost: Again, to repeat, you are getting these funds at VERY low costs. To get a sense of how much you’re saving, you can read this post about fees.
- Low Maintenance: As you can imagine, maintaining three funds is much
lesstime consuming than trying to maintain twenty (or more!). Again, simplicity is key.
IMPLEMENTING YOUR PLAN
Now that you have this background information, it’s time to follow through with a plan. Steps include making a final decision with your funds, deciding your asset allocation, and determining which accounts would best accommodate these funds.
Larimore also discusses the importance of how taxes play a part in your decision-making. Your investments will have different tax treatments based on their account location.
It can be hard to believe that such a simple portfolio can outperform so many active managers who dedicate a lot of time and energy in managing their portfolios. The creation of index funds has truly allowed for regular folks, people who work outside the financial industry, to feel more empowered and confident as investors.
Even if you are not a complete DIY investor, you will at least gain some basic knowledge about how investing works and what you can do to be a smarter investor. If anything, you should never outsource your investing with zero basic knowledge about investing- this is a huge risk that you are making with your
Should everyone use the Three Fund Portfolio strategy? Of course not. Each investor has their own risk tolerance, time horizon, preference, and goals. Some people would like nothing more than to use the three fund portfolio and move on with the rest of their lives. Others see this as an opportunity to put their own spin on the portfolio, truly making it their own. Who will ultimately end up with a better portfolio? If you’re measuring this by returns alone, then you’ll simply have to wait and see. There is no crystal ball, so you might as well choose a strategy that makes the most sense to you and stay the course.
This book is a slim volume and a quick read, providing information for both the novice and seasoned investor. Those that are just starting with investing will surely get a lot of value from this book. You can also find a wealth of information on the Bogleheads Wiki page. Wherever you are in your investing journey, make sure you give this one a read!
Here’s a quick link to the book on Amazon. Feel free to also check it out at your local library or visit your local bookshop!
Do you have a three fund portfolio? If not, what sort of funds do you have in your portfolio? Comment below!