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Simple Portfolios: 3 to 5 funds

On Monday I mentioned how easy it is to Invest for the Long Term. During that post I gave a general idea of how to do this easily. Today’s post will explicitly show you how to setup a Simple 3 to 5 fund portfolio in a matter of minutes. From this point investing for retirement is largely set it and forget it. After all studies by Fidelity have found that investor who forgot their investments frequently did better then those who regularly managed them.

Complicated Financial Investments

If you read Financial literature you will be bombarded with a multitude of ways to invest your money. Options trend from the exotic, venture capital, to the bizarre, did you know you can invest in Lawsuit settlements? Some of these are really out there but many more sound very reasonable. Some are even very in line with our current social media enthused culture, for example crowd funded investments in real estate or personal loans. There are so many investment options, so how do you choose? It’s just so overwhelming.

Exotic Asset Classes

If you are overwhelmed, then I suggest none of the investments I mentioned are for you. Sure you can make money investing in Real Estate, trading options, or even speculating on Cryptocurrency. But honestly in every one of these options you have to know what you are doing. Also in many cases these investments will do no better than much simpler investing approaches, and often much worse. Don’t you just wish there was a set it and forget it approach to investing where you don’t have to be Warren Buffet to get by? Or perhaps you don’t even know who Warren Buffet is… Well there is.

Keep it Simple Stupid (KISS)

Now everything up until this point has been around the idea of investing in some off the beaten path asset class.  It’s a time honored concept, but usually not true, that these investments will result in a road to riches. It’s also not necessarily an impossibility that one of these classes will result in you hitting it big. But in order for the to be so, you need to be both more savvy than your fellow human in this area and one of the first movers. If you read about it in money magazine than the cart probably already left the barn with the followers money. So if we assume most people just want to invest on the side then we are left with investing in the old standby, the stock market.

Passive versus Active Investing

There is more than one way to invest in the stock market though. The current method du jour is passive investing, or the art of investing in the entire market rather than choosing winners and losers. Basically a mutual fund or ETF (click here for a description of the difference) allows you to purchase a collection of stocks mimicking the actions of some stocks representing a portion of the economy. So for example you can invest in all the large cap stocks in the S&P 500, or focus on large caps in other countries via an all world fund. Numerous studies have shown that passive investing tends to exceed the return of active investing. There are three reasons for this:

  • It costs money to pay someone to make those active investing decisions. That cost tends to eliminate any potential return premium over the market.
  • It is nearly impossible as a human to separate your behavioral bias from your investing. As such people tend to make poor investing decisions when actively investing.
  • Some data and stock market theories validate that stocks tend to move randomly in the short term. Essentially the argument is that in the short run the price of all known information is valued into the stock. As such it is near impossible to choose a market beating stock in the near term.

3- Fund Portfolio: The Simple Portfolio

So we have established if you want to keep it simple you should invest in the market, and you should do so passively, but that still opens you up to a world of possibility. There are 1000s, but which ones to choose? That is where the 3 fund portfolio comes into play. The idea is simple. To cover the entire range of market options you really need three categories of stocks: The Total US market, the world market, and bonds. It just so happens that all 3 are available as mutual funds or ETFs from the large brokerages houses. So at it’s very simplest you could pick proportions of these 3 for your low cost brokerage of choice and be assured of beating the average investor who actively invests. Your knowledge of stocks can approach zero using this approach without negative consequence. All you need to do is know the percentage of each you would like to hold and yearly rebalance them to stay at your chosen percent.

Asset Allocation

You can read up on asset allocation percentages here. Honestly what percentages you choose is a factor of how soon you need the money, your risk tolerance, and personal preference. For the average non near retirement moderate risk person I would recommend something like 70% Total US, 15% international, and 15% bonds. In my case that would be just enough risk for my tolerance level. Anyway this article is not really about risk tolerance or asset allocation so consider this only scratching the surface there.

5- Fund Portfolio: Slightly More Complex Simple Portfolio

But what if you want to be a little more complicated. Perhaps you view a portion of the stock market like small stocks might perform better than large. Well the answer in this case is to add a few funds. You can add a small cap fund for domestic or international. If you are so inclined you could also add a more granular international fund that focuses on the Developed or developing world. Adding these funds as part of your proportion of their related 3 fund allocation will allow you to tilt your investing towards areas you feel are undervalued. So in my example above my 70% total US fund could be reduced to 60% and 10% be allocated to small caps. This would provide me a greater pro-proportion of US small caps then the overall market. And yet I still only have to manage 5 funds. I generally follow this approach, investing in 5 funds with a tilt towards small cap and large internationals. However, it’s helpful to know even this level of activity is not necessary to be successful investing in the stock market over the long haul. The 3 fund portfolio is an excellent choice, especially for those who do not have the time or inclination to determine how to invest.

Investing is Personal

Two final things to be aware of:

  • The stock market is not without risk no matter what approach you take. While the 3-5 fund approach is one of the better solutions, the future is not written. Invest only as you feel comfortable and based on your choices alone.
  • Those choices need not even be mathematical based. Take me for an example. I need to have some active involvement in my investing for my own sanity. I mitigate it by having a small portion of my portfolio set aside to play in the stock market. The portion is so small it has little to no impact on my overall portfolio return. However, this keeps the rest of my money in the simple portfolio, beating most active investors. Investing is personal, find what works, set an investing plan, and stick to it.

As always, Full Time Finance is not a financial advisor. Any investing you do is your choice alone with what you read here for entertainment purposes. Till next time..

 

4 Comments

  1. Turning Point Money
    Turning Point Money August 2, 2017

    I can’t disagree that investing in index funds is a great strategy for most investors, I do this in our tax deferred accounts. My issue (at least from my experience in 2008) is that some people who “set it and forget it” are the same people who bail when a correction happens. They miss out on the following years of bull market following a recession. Then they buy back in a the top and the cycle continues.

    I believe investors are better suited to understand what they are investing in and the reason for owning it. How many actually look behind the index fund to see how it is allocated across businesses and industries?

    This is why I prefer to personally allocate capital to individual stocks. I am less inclined to sell when trouble happens. Plus, I can tailor my investments to meet my strategy. Some folks may want to invest for yield, some to minimize risk during down years and some for the best risk adjusted total returns.

    • fulltimefinance
      fulltimefinance August 2, 2017

      There is the personal in finance. Whatever keeps you from wrecking your own portfolio by playing the market is probably superior to any other investment strategy you could choose.

  2. Emily @ JohnJaneDoe
    Emily @ JohnJaneDoe August 3, 2017

    I’m increasingly moving toward the same strategy, from one where I was far more active to one where the active portion is less important and returns are largely determined by a handful of passive funds. I had resisted it for a while after getting burned in crappy actively managed funds while my individual stocks performed better and grew faster through dividend reinvestment. I’ve realized, though, that was more due to the high fees with the funds I’d bought on my brokers’ recommendations than anything else.

    • fulltimefinance
      fulltimefinance August 3, 2017

      I found myself on much the same trajectory about 5 years ago. Passive funds certainly have become much more mainstream.

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