The art of simplicity in the three fund portfolio

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The 3 fund portfolio is a thing of beauty, easy to understand, easy to create and it can be implemented anywhere by anyone, so universal is its approach. So what is the 3 fund portfolio?

 

As the name suggests, it consists of 3 funds/ETF’s – a Global ETF, a domestic ETF (in my case an Aussie fund) and a bond ETF or fund. The portfolio works by striking a balance between global, domestic and safe harbour of bonds, and the simplicity of the fund means that you will rarely be checking in on your investments or be overly concerned with industry or geographic risk. The piece that really gets most people excited ? The portfolio weightings –  as a crude and general rule, the older you are, the more you should favour the bond fund.

 

Here is what a typical 3 fund portfolio might look like for a 30 year old in the UK:

 

60% Vanguard Global ETF – VWRA

30% Vanguard FTSE 250 ETF – VMIG

10% Vanguard Global bond fund – VAGS

 

At the age of 50, the portfolio may look like this:

 

40% – VWRA

35% – VMIG

25% – VAGS

 

And at 70, depending on the risk profile of course, it may look like this:

 

20% – VWRA

10% – VMIG

70% – VAGS

 

So why does the 3 fund portfolio advocate a split between global, domestic and bonds?

 

A well run Global ETF gives you a broad exposure to every market in the world, it distances you from the local market and the tendency to be overweight in your home market and allows you to benefit from established and emerging markets

A Domestic fund makes sense, because well its your home market, you are much less likely to be affected or concerned by currency risk and the dividends are already in the right currency (yours!)

And a bond fund, or any fixed income fund the simple reason why including the bond fund makes sense is it reduces your overall volatility and continues earning income when markets are down and/or when dividends are reduced. The safety that these type of ETF’s offer is incredibly attractive and the best part is that YOU decide the percentage of your portfolio dedicated to the bond ETF based on your own risk profile.

 

Ok, the 3 fund portfolio makes sense, want to know how to supercharge it?

 

This part again is incredibly easy and you can choose to use it or not. In the case of a severe, protracted market down turn there is way that you can truly capitalise by having the bond ETF. Here’s how – what happens in a bear market? Good ETF’s get ridiculously cheap and for those brave enough to catch a falling knife there are bargains to be had… However during the bear market all your funds are tied up in ETF’s , you are probably still contributing small amounts each month and taking advantage of dollar cost averaging but you cannot invest a lump sum in the market to take advantage of the downturn. With the 3 fund portfolio you can do one of two things – adjust your monthly/quarterly contributions to favour the downturn – for example if you are investing $1,000 in a 60/30/10% mix, you may choose to divert funds and invest 100% into the ETF that is in the bear market. The other option and the one that I personally favour as I believe it truly takes advantage of the market is to withdraw a lump sum from the bond fund and dump it into either the domestic or global ETF. I believe that this tactic really shows the value of investing in bonds or fixed income, its not ideal for everyone – what if you invest the lump sum in the first year of a four year bear market for instance? I have backtested this method on the Dow Jones index and the ASX 300 – it works if you wait for a double digit retraction in the indices, this doesn’t mean that you should invest the minute the market drops by 10%, the method worked best if the double digit drop lasted for three months or longer. The perfect entry point (albeit with the benefit of hindsight) was after two years of negative double digit returns – which is rare and has only happened twice in 40 years on the DOW. If an event like this happens again I would be tempted to not only dump the proceeds of the bond fund in but also use margin to get ahead – with the right checks and balances of course.

 

Please note that a lot of FI and FIRE investors do not try and time the market – we do not advocate it either, but in a confirmed bear market it may make sense to liquidate a fixed income fund and invest in a global or domestic ETF.

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