At its core, an index investing strategy is both very simple and very effective. One of the best index portfolio models that I have come across—and the one that I myself follow—is called the “three-fund portfolio.” The architect of this portfolio is investor, author, and chief Boglehead Taylor Larimore. (If you’re first hearing the term “Bogleheads,” this is a self-ascribed moniker used for those who follow the investing philosophy of John Bogle.) When asked what is so special about the three-fund portfolio, Larimore replied, “The answer is simple: By owning just three low-cost total market index funds (Total U.S. Equity, Total U.S. Bond, and Total International Equity), investors have historically outperformed the vast majority of mutual funds over time” (The Boglehead’s Guide to the Three-Fund Portfolio xvii).
“By owning just three low-cost total market index funds…investors have historically outperformed the vast majority of mutual funds over time.”Taylor Larimore
The nature of index funds means that this portfolio is extremely well-diversified, low-cost, does not take unqualified risk, contains no overlap, and has historically provided strong performance. The three types of funds used in this portfolio model correspond to the three asset classes that I believe most investors should consider. Let’s take an in-depth look at them. I’ll say at the outset: this is going to be a long post, but stay with me. It’ll be worth your time, I promise!
U.S. Total Stock Market Index Fund
This type of fund aims to “capture” the entire U.S. stock market in terms of the stocks that comprise it. Some, like Vanguard’s Total Stock Market Index Fund (VTSAX), hold literally thousands of stocks, all of them weighted to reflect their market capitalization within the overall stock market. As a result, purchasing a share of these funds is essentially the same as purchasing a share of the entire stock market; for this reason, John Bogle referred to it as “owning the stock market.”
I believe it’s important to know exactly what you’re buying, so let’s go over some key aspects of investing in the U.S. market—and how indexing fits into it all. We’ll use VTSAX (mentioned above) to illustrate these points.
- Sector. When we refer to the “sector” of a given stock, we are referring to the broad industry that it’s associated with. There are 11 total sectors in the U.S. market, such as energy, real estate, healthcare, information technology and consumer staples. Each of these sectors has a certain weighting in the market, which refers to its total valuation compared to that of the entire market. For example, the information technology sector currently makes up 24% of the entire market, healthcare makes up 13%, and so on. As you’d probably guess, these weightings are always changing, depending on how the sector valuation changes in aggregate. Here’s the important part: when you buy a total U.S. stock market index fund, you are buying into each and every sector according to its weighting. In this, you are fully diversified across all sectors within the U.S. market, and as a result you avoid taking on sector risk, which comes from putting too much of your portfolio into a given sector—predicting that it will outperform over time. (A good object lesson for sector risk is to look back at the Dot Com Bubble, when excessive speculation in the tech sector created a bubble that subsequently burst. The Nasdaq lost 77% of its value by October 2002.) If you’re curious, here’s the current sector weighting breakdown for VTSAX.
- Size. When we talk about a company’s “size,” we are referring to its market capitalization, or the total market value of the company. There are three main sizes you will hear about: large-cap (large-sized companies, or those worth $10 billion to $100 billion), mid-cap (medium-sized companies, or those worth between $2 billion and $10 billion), and small-cap (small-sized companies, or those worth between $250 million and $2 billion). As you might have guessed by now, when you buy a total U.S. stock market index fund, you are diversifying across the market weighting of each size category as well. Currently, this means in VTSAX, you are investing in roughly 72% large-cap, 19% mid-cap, and 9% small-cap stocks, which reflects the size make-up of the entire market itself.
- Style. The final category we’ll look at is what is called a stock’s “style.” Much is made about style, and entire schools of thought go into analysis along these lines. We are not going to spend too much time here, so here’s the short version. The two main styles you will hear about are “growth” and “value” stocks. Growth stocks are those which are perceived to have strong future earnings potential; for example, this might mean a smaller company with a promising new product, or a larger, more established company which is run so well it is expected to outpace the competition. Value stocks, on the other hand, are companies whose stocks are perceived to be undervalued; think of a company who takes a hit in public perception (but still has solid underlying fundamentals), or a hotel chain during COVID, which suffered temporarily but was fully expected to rebound after the crisis had passed. Here’s the important part: growth and value stocks tend to take turns outperforming each other. One outperforms the other, and then the pendulum inevitably swings and the opposite takes hold for a while; it’s cyclical—with the cycles being unpredictable. And trying to predict which one will outperform during your particular investment window is just another form of risk (style risk). Fortunately, there is a better option: own both (a mix of growth and value is called blend). And with a U.S. total stock market index fund, you do. If you’re curious, here’s the current breakdown for VTSAX, and by extension the U.S. market. The numbers in the boxes are the weighting percentage of that size-style intersection; for example, 17% of the fund is held in large-cap value, 26% in large-cap blend, and so on.
So, to recap: by investing in a total U.S. stock market index fund, you are fully diversifying across sector, size, and style lines. It’s important to note that these funds typically track the U.S. market very closely (index tracking for VTSAX, for example, is 99%). Another important note: if a total market fund is not available, a great alternative is a fund that tracks the S&P 500 (such as the Vanguard 500 Index Fund). As we’ve covered previously, the companies that make up the S&P are so large and influential, they make up about 82% of the entire market. As a result, the S&P tracks very closely with the total market, and a fund that tracks the S&P is a near perfect proxy for a total market fund.
International Stock Market Index Fund
International stock index funds aim to capture as much of the international stock market as possible. As you can imagine, there are many different market indexes representing international markets, and it can be complex to navigate. Generally speaking, the international stock funds I recommend meet the following criteria. Here, we’ll be using Vanguard’s Total International Stock Index Fund (VTIAX) to illustrate the concepts:
- They are ex-U.S. funds. These funds exclude U.S. stocks in their selections, which is important to avoid overlap, as we already have U.S. stocks covered with our U.S. stock fund. For example, VTIAX chooses the FTSE Global All Cap ex US Index as its benchmark; this is an index that contains stocks from countries all over the world outside of the U.S.
- They are broad-market. Much like the U.S. total stock market fund, this means they contain a wide selection of stocks from the countries represented in the fund. VTIAX, for example, holds an astonishing 7,554 stocks from 44 countries around the globe.
- They are low-cost. VTIAX, for example, has an expense ratio of only 0.11%, and a turnover rate of 7%.
- Finally, they contain both developed and emerging international markets. We will cover these next.
It’s important to note that the concepts we covered above for U.S. stocks (sector, size and style) apply just as well to international stocks. We don’t need to revisit those here. I do, however, want to cover the two broad classifications of international markets: developed and emerging markets.
- Emerging markets. Emerging markets make up about 25% of the total international market capitalization. These are countries that are still in the process of developing a stable and thriving economy. Said another way, emerging markets are in the process of becoming developed markets, but are not there yet. The reasons can be varied: some have pre-industrial economies, isolationist forms of government, substandard infrastructure, lower standards of living, and so on. Here’s the thing to remember: emerging markets do have some additional risks (such as the risk of political instability, or iffy regulations and accounting standards), but also offer the potential for higher growth. As emerging markets make the transition into developed markets, this tends to come with rapid growth, which can translate into higher returns for investors. Examples of countries classified as emerging markets are China, Russia, India, and Mexico.
- Developed markets. Developed markets account for the remaining 75% of international market capitalization. These countries are stable, with well-established economies and widespread infrastructure in place. Developed markets are those that tend to be heavily connected to (and derive benefits from) international trade, have relatively stable political systems, and have higher standards of living. Developed markets are generally less risky than emerging markets, but also offer somewhat less opportunity for growth, as they are not rapidly undergoing change. Some examples of developed international markets include Japan, Canada, the United Kingdom, and Australia.
The funds we will be using for international diversification include both developed and emerging markets, and as such you will be diversified across both categories. For example, if you’re curious, here is the list of top 10 holdings for VTIAX (countries listed by weighting inside the fund). As you’ll notice, both emerging and developed markets are represented.
There is quite a bit more to say, but we’re going to leave our discussion of international markets here for now. Diversification internationally is an area of debate in various investment circles, and due to this, we will be covering it in depth (in Part 10) when we get to asset allocation.
Bond Market Index Fund
To put it simply, bond market index funds should be kept low-cost, and diversified across the different types of bonds available. Bond markets work a bit differently than what we’ve covered so far with stocks, and we are going to look at two basic considerations as it comes to bonds: credit rating and term. Remember from Part 4 that a bond is simply an instrument that represents a loan made by an investor to a borrower (usually a corporation or government body). These loans can be structured over various lengths of time (or terms). And, depending on the borrower (as well as the length of time), the chances of repayment can either be near-certain or questionable; this is where a bond’s credit rating comes in. Let’s look at both of these concepts a bit more in-depth. To help, we’ll be using Vanguard’s Total Bond Market Index Fund (VBTLX).
- Credit rating. As we’ve discussed before, there are several institutions that have developed rating systems to evaluate the riskiness of a particular bond. One of the best-known is Standard & Poor’s, which assigns every bond a grade, ranging from AAA (best, or least risky) to D (worst, or most risky). This gives potential investors a short-hand way of gauging the risk of a particular bond. Bonds that fall in the range of AAA down to BBB- are considered “investment grade,” meaning they are generally a safe way to invest in bonds with minimal risk. Bonds that fall below the level of BBB- are known as speculative bonds, sometimes earning the fascinating name of “junk bonds.” Here’s the important part: one of the main reasons we invest in bonds is as a “portfolio stabilizer,” which means that they help preserve wealth when stock markets do what they do and get all unruly. Because of this, bonds aren’t the place that we want to take our risk; and this means we want to stick to investment grade bonds (BBB- or greater). Here’s the breakdown of the bonds included in VBTLX by credit rating:
- Term. Bonds can also be categorized by the length of time the loan is good for; this is measured by the amount of time from the issuance of the bond to its maturity date (when it is redeemed), and is known as a bond’s term. There are three major terms when it comes to bonds: short-term (less than 5 years), intermediate-term (5-10 years), and long-term (more than 10 years). The term of a particular bond also directly affects its risk level. Longer term bonds are less likely to be repaid (after all, who knows if a given company is even going to be around in 20 years?) and they are more sensitive to changes in interest rate. Because of this, long-term bonds carry higher coupon rates than short-term bonds. This variance in risk and return profiles is precisely the reason we want to be diversified across bonds of all terms as well as credit rating (above). Here are the various terms for the bonds included in Vanguard’s VBTLX.
Here’s the important part: by combining these two concepts, we will ensure that we are fully diversified across bonds of varying terms while still staying in the safer risk zone provided by investment-grade bonds. This gives us a broad-market “index” of sorts regarding the bond market, and covers it all in a single fund.
Putting It All Together
We’ve covered a lot. By now, you’re probably beginning to see the potential of this strategy. By owning all three of these funds, you essentially “own” the entire U.S. stock market, international stock market, and the U.S. bond market—all at very low cost. The diversification potential of such an approach is staggering. For example, combining Vanguard’s three funds mentioned above (VTSAX, VTIAX, and VBTLX) means that you will own 11,335 stocks (from around the globe), as well as 10,156 investment-grade bonds. Also, because stocks and bonds are typically inversely correlated (stock values rise when bonds fall, and vice versa), it helps cushion your portfolio against different market conditions (as well as manage portfolio risk). It doesn’t get more diversified than that. And, as Taylor Larimore mentioned above when we first set out, this portfolio has been shown to outperform the vast majority of active funds over longer time periods.
Combining Vanguard’s three funds mentioned above (VTSAX, VTIAX, and VBTLX) means that you will own 11,335 stocks (from around the globe), as well as 10,156 investment-grade bonds.
But what if you don’t have access to the three funds we’ve been discussing above? Don’t worry—they are not the only ones. There are index fund options that are just as competitive from nearly every major brokerage you might have access to. We’ll discuss how to research and select funds in Part 11 (along with a long list of some of my favorites). And with the introduction of exchange-traded funds (ETFs), this means that you can now even invest in specific funds across brokerage lines (such as buying Vanguard funds at Fidelity) without any additional costs. The question of mutual funds vs ETFs is one that tends to get a lot of traction with investors, so we are going to spend Part 8 weighing out the advantages of each.
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