The Three Fund Portfolio Asset Allocation Strategy

Good investing is all about being properly diversified based on your risk tolerance. Let me share the three fund portfolio asset allocation strategy for better investing.

“Don’t put all of your eggs in one basket.”

Not just lore, there is modern investing research to support this age old maxim. In investment terms, diversification, based on a variety of asset classes will protect your portfolio from unsystematic or firm specific risk. This is the risk that comes when one company or one sector of the economy declines.

For example, who on Earth could have forecasted that the global economy would shut down for three or so months due to the coronavirus pandemic? March 2020 saw the swiftest stock market decline in history. Thankfully, most of the indices have rebounded. But still, danger lurks ahead.

The asset allocation diversification works best when the various assets are inversely correlated. In other words, when one asset moves down, the other does not move in lockstep, but moves upwards.

Harry Markowitz, Nobel prize winner and widely accepted founder of Modern Portfolio Theory created investment portfolios of less correlated assets. He showed that including a variety of asset classes, the investor realizes a greater return with a lesser amount of risk (as measured by variance or standard deviation). In other words, your portfolio value is less volatile and the returns are maximized with less correlated assets.

Yet, there’s more to diversification than throwing a few different stocks, bonds, or funds into a portfolio. First, how not to diversify. Then find out if you can obtain a diversified portfolio with only 3 funds.

The Three Fund Portfolio

Let’s imagine you work for Facebook (FB), and all of your investment portfolio is held in Facebook stock. That’s great when FB is skyrocketing. But when the company misses an earnings estimate or realizes a decline in revenue and FB stock price declines 40%, so does the value of your nest egg. Notice, on the chart below, the volatility of FB stock price.

Consider this hypothetical example.

Continuing with the FB example, assume you’re a bit wiser and decide to diversify. As the price chart illustrates, FB price is quite volatile.

You include 50% in Vanguard Total Stock Market Index Fund (VTSMX) and 50% in FB stock. Assume that over the same period, the total return index fund increases 5%. Instead of experiencing a 40% decline, your portfolio only declines 17.5% [(.50 x -.40) + (.50 x .05)].

How does this return scenario work?

A total return fund such as VTSMX holds a proxy for the entire U.S. stock market, weighted by market capitalization. So, if the value weighted average of all the stocks goes up 5% during the time period, then your investment in the Stock Market Index Fund will also go up approximately 5% (less a small amount for fees and expenses).

How can it be that the overall market goes up 5% and FB stock goes down 40% at the same time? Individual stocks are subject to firm specific risks and can be very volatile. A lawsuit, missed earnings, or failed business initiative can all drastically impact the price of an individual stock causing a large price drop.

See how just a slight change in a portfolio's asset allocation reduces loss. Next, add a bond fund. Bond fund returns are less correlated with stock returns so it's important to include bonds or bond funds in a diversified portfolio. Your newer more diversified portfolio looks like this:

Assume the diversified bond fund returned 2.5% during the same time.

What would cause the bond fund value to increase 2.5%?

First, a bit color on market interest rate movements. Typically, market interest rates are driven by the Federal Reserve Bank's (the Fed) interest rate policy. When the Fed rate is mentioned, it usually refers to the rate charged between member banks on overnight loans. In general, market interest rates usually the direction of the Fed Funds Rate movement.

There is a basic tenet about bond price movements. Bonds prices move inversely with interest rates. This means that when interest rates decline, a bond funds value will increase. Assume that during this time period interest rates fell, and that decline increased the value of the bond fund 2.5%.

On the other hand, stock price movements are not as predictable as those of bonds. Typically, stocks advance more when interest rates are lower, but not always. The benefit of holding both stock and bond assets in a portfolio is that there is a lower correlation (albeit less predictable relationship between stock and bond price movements).

According to Matthew Boesler in a May 30, 2013 article, “Why Stock and Bond Markets Are So Confusing”, historically when the 10 year Treasury bond yield is below 3%, stock and bond yields tend to move in opposite directions. This relationship hasn't held when 10 year Treasury yields have trended above 3%.

FB Stock, Stock Fund, Bond Fund Portfolio

The new more diversified portfolio period return improves. Although this more diversified portfolio still suffers a loss, due to the oversized 40% FB decline, the total portfolio loss is minimized to – 10.82% [(.333 x -.40) + (.333 x .05) + (.333 x .025)].

Clearly, more than one asset is important to maximize return and minimize risk. The Facebook example demonstrates how holding a large percent on one stock subjects your portfolio to great risk.

How much diversification does one really need?

Historic Asset Class Returns

The most common asset classes include stocks, bonds, and cash (Treasury bills) equivalents. As the following chart illustrates, in the past stocks offered the highest annual returns, approximately 9%, with cash equivalents or Treasury Bills the lowest at under 4%.

A stock asset class contains individual stocks, groups of stocks combined and sold as mutual funds, as well as many additional categorizations within the broad stock category.

The bond and cash categories are also considered the fixed income asset class. Fixed income investments receive regular payments in the form of bond (bond interest payments are called coupon payments) or savings account interest payments.

If an individual bond is held until maturity, the bondholder receives the face value of the bond. For example, buy a ten year $1,000 government bond paying 2.5% interest (interest is paid twice per year). Every six months you receive $12.50 (.50 x $25). At the end of ten years, you receive the $1,000 or face value of the bond.

If you decide to sell the bond before maturity, then you may receive more or less than $1,000, depending upon the value of the bond at the time of sale. As mentioned earlier, this interim value will be driven by the interest rate movement between the date of purchase and maturity date.

There are many varieties of bonds for that particular asset class. Governments, municipalities, and corporations issue bonds for this asset class. Regardless of the type of bond, it's basic characteristics and movements with relation to interest rates hold constant. Bond mutual funds are also included in this asset class. 

The cash asset class refers to bank savings accounts, money market mutual funds, and short term U.S. Government Treasury bills.

Successful Asset Allocation also mentions alternative asset classes such as real estate, commodities, and precious metals. Some investors add these categories as well. Although, there are professionals who state that access to real estate and commodities is embedded within a diversified stock portfolio.

Real estate can be held in real estate investment trusts (REIT), a type of real estate mutual fund. Real estate investments are also influenced by interest rates because as interest rates rise, borrowing costs for real estate mortgages also increase. Thus, when interest rates rise, the REIT funds normally fall and vice versa.

According to “The Business Cycle and the Correlation between Stocks and Commodities”, by Bhardwaj and Dunsby of SummerHaven Investment Management, the correlation between stocks and commodities over the long term is approximately zero.

That is the weakest correlation between asset classes and in effect suggests there is little diversification benefit from adding commodities. That said, business cycles and types of commodities may have diversification benefits.

Given the plethora of potential investments and asset class alternatives, one would think that you need at least a handful or two of asset classes in order to be properly diversified and garner the greatest return for the least amount of risk.

Broad asset allocation across many asset classes may not be crucial to investing success.

3 Asset Classes Versus 11 Asset Classes Portfolio

The 3 asset class portfolio demonstrates that one does not need a complicated investment portfolio with in order to garner market matching long term results. This discussion is not to recommend a 3 asset class portfolio, but to illustrate its viability for those investors looking for simple-to-manage investment holdings.

Below are two diversified investment portfolio choices. The first holds 3 diversified mutual funds while the second holds 11. The 3 asset class portfolio holds 67% stock assets and 33% fixed. The more diversified 11 asset class portfolio contains 60% in stock assets with 40% in fixed assets.

Paul B. Farrell, from the Marketwatch WSJ website keeps tabs on total returns for 8 Lazy Portfolios. Data from two of these portfolios is reflected below (Scott Burns Margaritaville Portfolio and Fundadvice Ultimate Buy and Hold).

On the surface, given stocks historical out performance, you would expect the portfolio holding a greater percentage (67%) in stock funds to outperform the portfolio with a smaller percent (60%) in stock holdings. So, the perfectionist would argue that this isn't  a perfect comparison as the asset allocation percentages aren't comparable.

Let’s remove this allegation with the retort that investing is not a perfect science and this study is an attempt to show one can obtain excellent returns with a 3 asset class portfolio.

The 3 asset class portfolio had a 10 year annualized return of 6.22% versus 6.15% for the 11 asset class portfolio. Drill down to 1 year return and the fewer asset classes portfolio bested the 11 funds by 1.00%.

The one year return of the 3 asset class portfolio was 8.51% versus 7.51% for the 9 funds. The recent 5 year annualized returns also favored the 3 fund portfolio.

Unpack the Portfolios

Why did the 3 asset class portfolio outperform the 11 holding portfolio? The simplest explanation is due to the fact that during the period in question and given the specific period stocks outperformed other asset classes. Thus, the out performance may be attributed to the broad asset allocation decision.

With the multitude of diversified index fund opportunities, choosing one fund over a similar one in an approximate index may lead to higher or lower  of returns. For example, the Vanguard Inflation Protected Securities Fund could just as easily been replaced with a total bond fund index fund.

The 3 asset class portfolio held 67% percent in stock assets (stocks historically outperform the fixed asset classes) and the 11 asset class portfolio held 60% percent in stock assets.

In long term investing, 10 years is a relatively short period of time. It is possible that given more time, the 3 asset class portfolio might under perform the more more broadly diversified portfolio. This example demonstrates that a 3 asset class is a viable option for those investors looking for a simple approach to investing.

Although Vanguard funds were chosen for this example, there are many additional index funds from which to choose. In fact, most mutual fund families offer comparable low cost index funds. When investing, its important to be aware of the annual fees. Any money going to the fund company is not working to grow your wealth.

For the investor interested in the simple path to wealth building, a 3 asset portfolio offers an investing choice which requires very little management. The investor chooses his or her preferred asset allocation, invests in the three funds according to the predetermined percentages and rebalances once per year. It doesn't get any easier than that, or does it?

Target Date Retirement Funds

Taking the concept of easy investing one step further, there is another option, target date mutual funds. Responding to the investor’s desire for simple investing alternatives, the investment industry created the target date mutual fund.

This composite fund includes a variety of stock, bond, and cash funds combined in various asset allocations. As its name implies, the fund is designed for individuals who designate a date when they will begin withdrawing their funds. This date is usually commensurate with a retirement date

As one would expect, the further from the target date, the more stock funds are held in the portfolio. As the target date approaches, the fund rebalances to hold more fixed and less stock assets. Normally, each year the fund adjusts its asset allocation and rebalances to become a bit more conservative.

For example, a worker born in 1975 who wants to retire at age 65 might choose a target-date 2040 fund. Whereas, an older worker, born in 1957 who expects to retire in 2022, chooses the target-date 2022 fund.

If this sounds too good to be true, it may be as there is some conflict surrounding these types of funds. The critics argue that target date funds don’t consider the risk tolerance level of an individual investor. Expenses may also inch up on these funds in contrast with the fees on an individually managed portfolio of index funds. Add to those concerns the fact that different mutual fund companies structure their funds with varying assumptions.

These criticisms should encourage an investor to peak under the hood of a target date fund before investing. Check out the underlying funds and asset allocation included in the target date-fund. Compare how Target Date Fund A allocates among stocks, bonds, and cash in comparison with Target Date Fund B. Are you comfortable with the percentages in each asset class?

As with all investing, fees matter. Every dollar spent on management is one less dollar growing your wealth. Thus, look at the annual percent per year spent on fees. With your own diversified portfolio of index funds it’s easy to keep the average annual fee under 0.50%. Find out how the target date fund fees compare.

Both my children's 529 portfolios are in target date funds.

Summary Of The Three Fund Portfolio

Whether you should invest in a 3 asset class portfolio, an 11 asset class portfolio, or a target date mutual fund is a personal preference. The decision should consider how much time and attention you want to spend on your investments. For the individual who wants respectable returns with minimal effort, a 3 asset class portfolio or target date mutual fund is a viable option.

Realize that no matter how many asset classes you prefer, diversification can only take you so far. As mentioned earlier, diversification can eliminate firm specific risk. No amount of diversification can protect you from systematic or market risk.

Invest In Real Estate As Well

I strongly recommend everyone consider diversifying into real estate as well. Real estate is actually my favorite asset class to build wealth because it is tangible, provides income, is less volatile, and generally does well when stocks due portfolio. With mortgage rates at all-time lows in 2020+, real estate should continue to do well.

The easiest way to invest in real estate is through Fundrise, one of the leading real estate crowdfunding platforms today. They operate several private eREITs that allows you to diversify into various types of commercial and residential real estate opportunities across the country. It's free to sign up and explore.

For individual commercial real estate opportunities, take a look at CrowdStreet. CrowdStreet primarily focuses in real estate investment opportunities in 18-hour cities, those cities with lower valuations and faster growth due to demographic shifts. With work from home now commonplace, it is likely more people will escape expensive and densely populated areas like NYC to lower cost areas of the country. CrowdStreet is also free to sign up and explore.

When investing, it’s important to grasp that there will always be ups and downs in your investment portfolio, but for long term investors with a successful asset allocation, the historical return trend has been upwards.

Input your investments into Personal Capital’s dashboard and see how your portfolio stacks up. And if you’re looking for a respected advisor, Personal Capital can help as well.

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