Investment Portfolio that will Outperform Most Investors and Active Fund Managers

How long does it take to manage the money your have worked so hard to earn? Less time than you think.

My Early Days of Investing

It can be a daunting task to come up with a portfolio that has the right level of risk and volatility, has enough diversification and consistently provides returns that you expect to grow your net-worth. When I got my first job back in 2004 and was starting out investing in 401K, I thought I was very smart and could build a portfolio that could give me solid returns without going down with the market. I had no understanding of good asset allocation or how to split between stocks vs bonds. More than anything else, I enjoyed managing money since this was the first time I was doing it. I studied summaries of all the funds and focused on past returns (how foolish can one be) to invest my money. I would check my balance every few months, and not being satisfied with the returns I was getting, reallocating to different funds, only to repeat the process and getting average returns. But it wasn’t until years later that I educated myself about personal finance and investing and realized how easy it is to build a winning portfolio without spending hours trying to compare 2000+ funds out there only to end up guaranteeing that the fund managers get the best of your money.

Simple Effective Three-Fund Portfolio

This can be achieved using a broad-market index fund that reflects the collective portfolio of all market participants and their view on the value of its holdings. Here is how to build a winning portfolio in less than 1 hour.

Step 1: Invest in the Market

A vast majority of fund managers are trying to beat the benchmark indices. Yet most of the managers under-perform. So why not buy the underlying market index and at least be assured the return that the market index is getting? The S&P 500 is one of the most popular benchmarks in U.S., certainly the one most stock fund managers are trying to beat. If an investor were to buy an index fund chasing S&P500 would have gotten an annualized return of 10.1% since 1927.

Step 2: Add some Fixed Income

While investing in S&P500 will provide the yield you need in the long-term, there will be periods of high volatility along the way. During the downturn of 2008-2009, stocks were down 40% from the peak. Adding some fixed income to the portfolio will smooth out the ride during those high volatility periods. Historically, bonds produced an annual average return of 5.8 percent from 1926 through 2009. While  the return on bonds is smaller than stocks, they are more consistent than stock returns over long-term.

Step 3: Add International Exposure

Now add some international funds to give exposure to growing international markets and get higher returns. It also provides diversification away from U.S. stocks while reducing your overall volatility of your portfolio. Since domestic and international stocks are exposed to different economic and market forces, their returns have not been perfectly correlated.

That’s it. You have a good portfolio to start with that will beat about 80% of active fund managers.

How To Create Three-Fund Portfolio

Here are three simple index funds you can use to build a diversified portfolio.

  • Vanguard Total Stock Market Index Fund (VTSMX)
  • Vanguard Total International Stock Index Fund (VGTSX)
  • Vanguard Total Bond Market Fund (VBMFX)

Allocate 40% of your total assets to Vanguard Total Stock Market Index (symbols VTSMX, VTI). This fund gives you the entire U.S. stock market—large, midsize and small companies—for 0.05% annually. (That means you pay $5 a year for each $10,000 invested to cover expenses.). 

Put 20% in  Vanguard Total International Stock Index Fund  (VGTSX)

Put the remaining 40% in  Vanguard Total Bond Market Index Fund (VBMFX). This is a simple 60-40 portfolio with 60% in stocks (40% U.S. stocks and 20% international stocks) and 40% in bonds.

If you have a longer (15 to 20 year) time horizon or want to be more aggressive, change the allocation to 80-20 or to 40-60 for a shorter time horizon. Below are examples of 80/20, 60/40 and 40/60 investment portfolios.

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Other Benefits of Three-Fund Portfolio

Besides being extremely simple, here are other advantages to this portfolio.

– Average fees is less than 0.2%, compared to above 1% most advisors and mutual funds charge

– No individual stock or sector risk

– Very tax-efficient in case you want to hold it in taxable account

– Good diversification due to no overlap between funds

– Automatic rebalancing within each fund

– Easy to balance between three funds

– Certain to outperform most individual and professional investors

The simplicity of this portfolio is so effective that Jack Bogle, the founder of Vanguard said “After a lifetime of investing since 1950 trying to beat the market, I am convinced that a simple 3-fund (or ETF) portfolio of Total Stock Market, Total International, and Total Bond Market, properly allocated, is an ideal portfolio for most investors.”

Creating Three-Fund Portfolio with Vanguard

The easiest way to create this portfolio is to open a brokerage account at a firm that allows you to invest in index funds. I would strongly recommend Vanguard, which is where I have my investment accounts. More importantly, most of the Vanguard funds are the cheapest in their category. If you decide to invest with another brokerage, you can search for similar funds and construct a portfolio at most of the major brokerage funds like Fidelity, Charles Schwab and Trade.

Whether you decide to use this simple three-fund portfolio for your investing or another strategy, the key is to have the discipline and stay course during various market fluctuations.

Tools I use to track my accounts and achieve financial independence

The best way to build wealth is to keep your investments simple, diversified, automatic, and low-cost. The key is to determine a system that works for you, execute it and automate, so you don’t have to lose sleep managing it on a day-to-day basis.

Whether you are a do-it-yourself investor like I am or just getting started with investing, you should check out Betterment. For fees as low as $250 per $100,000 invested (0.25% expense ratio) you get simple, diversified, and automated investing. In addition every account gets free features like Tax Loss Harvesting+ which allows an investor to avoid taxes and increase returns, making the 0.25% management fees worth the extra returns.

I use Betterment for a part of my investment portfolio and recommend it to my family and friends who are getting started in investing or want a simple hands-off investing approach without having to learn about asset allocations, diversification, or rebalancing. It’s a simple set-it and forget-it system that is very cost-efficient and simply works.

Another tool that I personally use and recommend is Personal Capital. I have investment accounts all over the place and its easy to lose track. I use Personal Capital to keep track of all my financial accounts in one place. While they have a paid service where they can manage your funds, the best features are all free. Besides managing all your financial accounts in one place to track your net worth, it allows you to analyze 401K fees and helps you analyze your portfolio allocation and even suggests ways to save fees and improve your asset allocation and performance.

I use Personal Capital to track all my accounts like 401Ks, IRAs, bank accounts, 529 accounts, Betterment and peer-to-peer lending accounts, all in one place. It’s free, secure and presents me with a one-stop dashboard so I can see all my money on one site and track my net worth.

I will be writing a full review of Betterment and Personal Capital in future posts to show how easy it is to use these tools and how these can save hours while keep your investment goals on track.

P.S. – If you would like to sign up for Betterment or Personal Capital, I would appreciate if you use the links above. I do get a small benefit if you sign up using the links above.

What investment strategy do you use for your portfolio? Are you satisfied with your allocation or looking to change? Please share your thoughts and comments below.

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