﻿When it comes to investing in the stock market, I firmly believe that the 3-fund portfolio is one
of simplest, yet the most effective strategies to follow. Therefore it’s not a surprise that
most target retirement funds and target date funds follow this strategy as well.
When I look at my own portfolio and compare it side by side with a similar Target Date fund,
I find that the asset allocation and the funds are quite close to each other. So the big question is
why not keep it simple and just invest in Vanguard Target Retirement Funds? Hi, if you are new to
the channel, my name is Tae from Financial Tortoise. Where we learn to grow our wealth,
slow and steady. In today’s video we are going to deep dive into two of the most popular investment
strategies: the do-it-yourself, 3-fund portfolio strategy and then set it and forget it target date
fund strategy. They both have their strengths and weaknesses and they appeal to different
types of people, so let’s take a look at which strategy might be best for you. Let's briefly
go over what a 3-fund portfolio is. The 3-Fund portfolio was made popular by the Bogleheads - the
self-proclaimed avid followers of Jack Bogle, the founder of Vanguard group. They preach index funds
as a sure way to build wealth and advocate for the 3-fund portfolio strategy as a simple, but one of
the most effective ways to manage our investments. I don’t know if I would go out my way to call
myself a Boglehead, but I do align myself with a lot of their principles. Jack Bogle, the father of
index funds is famous for saying: “Simplicity is the master key to financial success” and I
completely agree with this statement. The three fund portfolio that the Bogleheads so highly
praise is, as its name implies, is made of three simple index funds: a Total U.S. Equity, a Total
U.S. Bond, and a Total International Equity fund. A total US Stock Market Index Fund essentially
holds every single stock in the US stock market. At the time of this video, there are approximately
4,000 publicly traded companies in the United States. Think of popular stocks like Apple, Google
and Amazon as well as some lesser known ones like Dollar Tree or M&T Bank. A specific Vanguard fund
would be Vanguard Total Stock Market Index Fund, also known as VTSAX. A total International Stock
Index Fund would include all stocks from the rest of the world excluding the ones headquartered
in the United States. At the time of this video, there are close to 8,000 international companies.
They include some familiar companies like Samsung, Nestle and Shell, as well as thousands you might
not know even existed. A specific Vanguard fund would be Vanguard Total International
Stock Index Fund, also known as VTIAX. A Total US Bond Market Index Fund would include all types of
bond you could think of. Varying credit quality ranging from US Government to Triple B and varying
maturities from short term to long term. At the time of this video, there are more than 10,000
bonds within this fund. A specific Vanguard fund would be Vanguard Total Bond Market Index Fund,
also known as VBLTX. Like a good cake, when you mix these three into a single portfolio, you get
the ultimate, DIY 3-fund portfolio. And the basic premise with this strategy is that if you were to
follow this simple plan throughout your investing journey, you will almost surely not only beat out
the majority of stock picking investors out there, but even the most professional investors. Alright
let’s talk briefly about Target Date Funds. They are sometimes called Target Retirement Funds or
sometimes Lifecycle Funds based on the investment firm, but the premise is the same. And they are
also called “fund of funds” because it holds several other funds within it. The index funds
that a target retirement fund holds are most often the same ones we would use for a 3-fund portfolio
strategy. However with some notable differences. Unlike a DIY 3-fund portfolio, a target date fund
will rebalance the asset allocation of the portfolio automatically as you get closer
to your retirement age. The basic investing philosophy is the same as a 3-fund portfolio,
but it makes investing even easier. You can think of it as the poor man’s financial advisor without
all the downsides of actually having a financial advisor. If you want to make good investment
decisions, but don’t have any desire to learn about portfolio design or investment strategy,
this one fund would literally be all you need for the rest of your life. It has automatically
built-in-diversification because it holds low cost broad market index funds, and it automatically
adjusts asset allocation as you get closer to your retirement age. A general rule of thumb is
that as you get closer to your retirement age, you want to hold more stable assets like bonds
and cash versus stocks in your portfolio. A target retirement fund does this for you automatically,
making your portfolio more conservative versus aggressive using different asset classes. Assuming
I want to retire when I’m in my 60s, my Vanguard specific Target Retirement fund would be Vanguard
Target Retirement 2045 Fund, also known as VTIVX. When we look under the hood of this fund what we
will notice is that the funds within VTIVX are actually identical to what we would have
selected for our 3-fund portfolio. It’s made up of Vanguard's Total Stock Market Index Fund,
Total International Stock Index Fund and Total Bond Market Index Fund. So the big question
many of us ask is, if the funds within the target date fund matches that of my DIY 3-fund portfolio,
why not just keep it simple and buy Vanguard Target Retirement fund? Set it and forget it,
right? Well, it’s not that straightforward. Let’s look at a few criterias that might make you lean
one way or the other. The first criteria of comparison is expenses. Expense associated
with each strategy and how it can affect your portfolio outcome. Most of Vanguard’s Target
Retirement Funds have an expense ratio of 0.08%. This means that if you had $10,000 invested,
Vanguard is charging you $8 annually to manage this fund for you. For comparison purposes I’m
going to use the Vanguard Target Retirement 2045 Fund’s individual fund allocation and
apply it to our own 3-fund portfolio. In this scenario the weighted average expense ratio of
our DIY 3-fund portfolio comes out to around 0.066%. VTSAX has an expense ratio of 0.04%,
VTIAX 0.11% and VBTLX 0.05%. For simplicity, I lump the Total Bond Market II Index Fund and the
Total International Bond Index Fund into one bond fund, since it is such a small allocation. So by
holding 3 separate funds instead of one, we save 0.014% in expenses per year. Now, does that sound
small to you or significant? It depends on the size of our portfolio and the time horizon. Let’s
assume an average return of 8.00% for the 3-fund portfolio and 7.86% for the target date fund given
the 0.014% difference in expense ratios. And let’s assume that I invest my $1,000,000 today in each
fund until my retirement 25 years from now. How much would I have in each fund? For the 3-fund
portfolio, the $1,000,000 would have grown to slightly under $7M ($6,848,475). For the Target
Date fund, the $1,000,000 would have grown to slightly over $6.5M ($6,629,952). A difference
of over $200,000. Definitely not a small amount for having to manage three funds instead of one.
Now of course I’m not factoring in rebalancing so it's not a perfect comparison, but the main point
is that even a small difference in expense ratios like 0.014% can have a significant difference in
the long run. But is this enough to say a 3-fund portfolio is a clear winner? Let’s take a look at
a few other comparison criterias. The second criteria of comparison is tax optimization.
There are naturally investments that are already “tax efficient” to begin with. Most often these
are stocks and mutual funds that pay qualified dividends - dividends that receive favorable tax
treatment. And stocks and mutual funds that avoid paying out taxable capital gains distributions.
Such distributions are typical of actively managed funds that engage in frequent trading
in their portfolios. Vanguard Total Stock Market Index Fund checks the box on both of these thus
is a great example of an already tax-efficient investment. The dividends it pays are modest
and mostly “qualified.” And because trading in the fund is rare, so too are taxable gains
distributions. On the other hand, investments that are “tax inefficient” are those that pay interest,
non- qualified dividends and those that generate taxable capital gains distributions. Individual
Stocks, Bonds, CDs and REITs fall into this category. And because of their tax inefficiency,
we would ideally like to keep them in tax advantaged accounts like 401(k) and IRAs.
Now when we are managing our own DIY 3-fund portfolio, we can allocate the different funds
to different tax efficient accounts. For example, putting the majority of our bond index fund into
401k and IRA. While being ok putting out equity index funds into non-tax advantaged accounts
like simple brokerage accounts because they are already tax efficient. However, when we follow
the target retirement fund strategy, we don’t have this flexibility. We can’t break out the
specific sub-funds. Everything goes into each tax advantaged or non-tax advantaged account equally.
The scale of the impact is again dependent on the size of our portfolio and time horizon,
but the bottom line is that when we manage our own investments, it allows for tax optimization
customization. The third criteria of comparison is asset allocation. Asset allocation simply means
What percentage of your total portfolio should you hold in total stock vs total international
vs. total bond index funds. And this is a crucial component to our investments because based on your
life stage, the allocation you decide will have a tremendous impact on your potential returns and
ability to retire. A general rule of thumb you want to understand is the relationship between
risk and reward and how it correlates to stocks and bonds. If you want to take more risks with
your portfolio, you want to hold more stocks. If you want to take less risk, then you want to hold
more bonds. But, when you take less risk, there are also less rewards - meaning potential for high
returns. Take a look at the chart here I borrowed from the Bogleheads Guide to Investing. This chart
shows maximum annual loss and the average annual return an investor would have incurred during the
period from 1926 to 2012 based on various stock to bond allocation. If you were to have been
100% in stocks, though your average returns would have been the highest at 10%, at your worst year,
your portfolio would have lost 43% of its value. Imagine if you were about to retire and your
portfolio just dipped by almost half its value. You’d either need to push back your retirement
or have a heart attack. Maybe a combination of both. Now imagine that you are very risk averse,
so you decided to go 100% bond. Ok, so you are protected from the worst annual loss to just 8%.
But, your average return is only 5.5%. By being so risk averse, you missed out on much of the gains
from the market. So based on your life stage and risk tolerance, you will need to decide how much
bond and stocks you feel most comfortable with. Are you the type that’s ok with riding the high
ups and downs of the market without letting your emotions get to you? The worst thing you want to
do when the market is down is to sell. Actually this is the time you want to be buying because
the market will eventually recover and you want to take advantage of that ride up. And this is
probably the biggest disadvantage of owning target date funds. You are not in control of your asset
allocation. The willingness to take on more or less risk is a very personal preference. You
could be a type that loves taking risks. Or you could be the complete opposite. Completely fine,
not taking any risks. We are all very different individuals when it comes to our risk tolerance,
and when you invest in Target Retirement Funds, you can’t factor in those personal preferences.
The fund has a risk profile formula it follows and you can’t change that. And you have to live with
the consequence of that asset allocation. However with a 3-fund portfolio, you can customize your
portfolio in ways that are not available with target-date funds. Alright, so based on what we
covered so far - the additional expense ratio, tax optimization and the lack of customization,
does a 3-fund portfolio trump target date funds? Well not completely. Because I do believe there
are good scenarios for target date funds. The first scenario where a target retirement fund
makes sense is if you are struggling with analysis paralysis. If you are watching all
these videos and delaying your investment because you are trying to find the “perfect” investment,
I would say just buy a target retirement fund and get started. There is no such thing as
perfect investment. Just one that works for you. Analysis paralysis is what keeps many
people from investing in the market. We are all afraid of making big mistakes. However,
the best way to learn is through action. Yes, you need some base of knowledge before jumping
into the deep end of the pool. However when it comes to investing, the difference between a DIY
3-Fund Strategy and a Target Retirement Fund is irrelevant when compared to not investing at all.
When you commit to investing, you will naturally learn more. There is something about having real
money in the market that focuses our attention. And know that just because you choose the target
retirement fund strategy today doesn’t mean you can’t change it down the line. For me,
this is what I personally did in order to just get started. I didn’t know where to start so I
started investing in a target retirement fund so I wasn’t constantly sitting in the sideline.
After a few years, as my knowledge grew, so did my confidence and I was able to transition to a
3-fund strategy. But this took time and if this is you, I would recommend starting out with a
target retirement fund strategy so you get the ball rolling. The second scenario where a target
retirement fund makes sense is if you want to save time above all else. As I mentioned earlier,
a target-date fund is like a poor man’s financial advisor. With just one decision, the target
retirement fund will give you a diversified portfolio, rebalance it for you, and ensure
you stay the course. All for a great price of just 0.08%. All you have to do is just keep investing.
If you want to be completely hands off and save time above all else, this could definitely be
worth it. I mean it surely beats paying some real financial advisor to do many of the same
things but charge you 1 to 2% versus 0.08%. The third scenario where a target retirement
fund makes sense is if you fear self sabotage. The 3 fund portfolio is great because it allows
us flexibility and freedom to customize our asset allocation. However, this could be a double-edged
sword. If you are a new investor and haven’t experienced many ups and downs of the market, you
could overreact to certain market corrections. For example, let’s say you never experienced a bear
market. Then you might start out too aggressive in your 3-fund portfolio in relation to your risk
tolerance. So when a market crash happens, which it always will, you might overreact and swing to
becoming too conservative afterwards. Holding all your money in cash because you didn’t enjoy
the roller coaster ride. In this case, a target retirement fund could be a good strategy because
it will force you to stay with a specific asset allocation regardless of how the market is doing.
That’s it guys. Thank you guys for watching and if you like to learn more about 3-fund portfolios
and target date funds, please check out my video here. Until next time, all the best.