Three-Fund Portfolio

Each fund has one job. The total US stock fund owns large, mid-size and small American companies, so it covers more of the market than an S&P 500 fund. The total international stock fund owns companies in developed and emerging markets outside the US, adding other economies and currencies. The total bond fund holds investment-grade US Bonds, from Treasuries to corporate debt, which usually fall far less than stocks in a downturn and pay steady interest.

Because every piece is a broad index fund, you get wide diversification without choosing a single security, and costs stay low. The template became popular among Bogleheads because it reduces investing to three decisions: how much to hold in stocks versus bonds, how much of the stock portion to hold abroad, and when to rebalance.

Start with the stock and bond split, your asset allocation, because it drives most of the portfolio’s risk and return. A long horizon and steady income from work can support more stocks; a need to spend the money soon argues for more bonds. Your risk tolerance matters too: the right mix is one you will keep holding after a 30% drop in stocks. Many investors shift toward bonds as retirement approaches, following a glide path like the one a target-date fund uses.

The international share is the second choice, and there is no official answer. Some investors hold non-US stocks roughly in proportion to their share of world stock market value; others hold less because their spending, debts and future income are in dollars. The formula below turns the two choices into three targets. A 60/40 portfolio with 40% of its stocks abroad, for example, works out to 36% US stock, 24% international stock and 40% bonds. Write the targets down, along with a rule for when to rebalance, so a bad year does not reopen the decision.

Returns pull the mix away from its targets. After a strong year for stocks, the portfolio holds more risk than you chose; after a crash, less. With only three funds, Rebalancing means comparing three percentages with three targets, on a calendar rule such as once a year or a threshold rule such as a five-point drift.

The cheapest way to rebalance is with new money: send contributions and reinvested dividends to whichever fund is underweight. When you must sell, do it inside a 401(k) or IRA, where trades are not taxed. Selling appreciated shares in a taxable account realizes capital gains, which can cost more than the drift you are fixing.

Most households hold a three-fund portfolio across several accounts, so measure the mix over the whole household rather than account by account. That leaves room for asset location. Bond interest is taxed as ordinary income, so the bond fund often sits in tax-deferred accounts. Stock index funds, which pay mostly lower-taxed qualified dividends and defer most gains until you sell, suit a taxable account better.

The international fund has an extra reason to sit in a taxable account. A fund that pays foreign taxes can elect to pass your share through to you on Form 1099-DIV, letting you claim the foreign tax credit, a benefit that disappears inside an IRA or 401(k), where the fund’s income never reaches your return. Under the Form 1116 instructions, if all your foreign income is passive, it is reported on payee statements such as Form 1099-DIV, and your creditable foreign taxes total $300 or less ($600 on a joint return), you can claim the credit without filing Form 1116.

A target-date fund packs a similar mix into one fund. It is typically a fund of funds that holds stock and bond funds and moves toward bonds on a preset schedule as its target year nears, rebalancing along the way. That is convenient, and it removes the temptation to tinker. The trade-offs are control and flexibility: you accept the fund’s glide path and international share, and because stocks and bonds sit inside one fund, you cannot put the bonds in a tax-deferred account and the stocks in a taxable one.

A three-fund portfolio asks for a little upkeep in return for choosing every weight yourself and placing each piece where it is taxed least. Costs can be similar. Compare the target-date fund’s expense ratio, which includes the fees of the funds it holds, with the blended cost of the three funds you would buy instead.