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Advantages and Disadvantages of the Three-Fund Portfolio

Last week, I explained the famous Three-Fund Portfolio and laid out its foundational elements. If you’re still on the fence when it comes to adopting this strategy, look no further. In this article, I’ll be going over a few advantages and disadvantages of the Three-Fund Portfolio.

To quickly summarize, the Three-Fund portfolio is an investing strategy created by an online community of personal investors, dubbed “Bogleheads'', after John Bogle, the creator of the index fund and founder of Vanguard. This strategy consists of purchasing and holding three index funds, a total US stock market fund, a total international stock market fund, and a total US bond fund. For a more detailed explanation, check this article out.

To preface, I want to say that I am not a registered financial advisor, everything I say is purely my opinion and for educational purposes only. I am not telling you to use this strategy, I am simply explaining it. Please consult a registered financial advisor before making any investment decisions.

To begin, let’s explore some of the different elements of this strategy.

The first and most obvious element of this strategy is simplicity. By owning the three funds part of this strategy, you quite literally have exposure to most public companies in the world and most bonds in the US. All this is done, again, with just three funds (simplicity). This might be good if you’re unsure of how to invest or just don’t have the time to devote to researching potential investments. However, if you're interested in a more hands-on approach and active stock picking, this strategy probably isn’t the best because it doesn’t include owning any individual stocks (this doesn’t mean you can’t own both index funds and individual stocks, just that this strategy doesn't allocate for single companies).

This leads us into another key element of the Three-Fund Portfolio: hands-off investing. As I mentioned, this strategy requires minimal management, so you don’t need to check your positions/holdings every day, analyze tons of graphs and financial statements, or worry about checking the news to see if the companies you own did something controversial. Again, this might not be the best if you want to play an active investment role and actually pick stocks.

Another element of this portfolio is diversification. This is one of the most “diversified” portfolios you can own, as you have some level of exposure to a ton of different sectors, regions, and companies. This means that your portfolio isn’t overexposed to one sector, so even if a specific area of the market, like natural gas, experiences a huge downturn, your portfolio won’t be affected too badly, as natural gas only makes up a small portion of your portfolio.

Like many of the points I discuss in this article, this can be both an advantage and a disadvantage; if you really believe in one sector and are confident it will do well, the Three-Fund portfolio may limit you from investing heavily in that sector. This means that if that specific sector does do well, as you predicted, you miss out on profits. However, if it doesn’t do as well as you predicted, you also miss out on the losses you would have taken on if you had invested heavily in that specific sector.

This instance embodies the principle of risk-adjusted return. In short, this principle states how the amount of profit you make is proportionate to the amount of risk you take on. The more risk you take on (putting all your money in one stock), the higher your returns/profits will be if the stock does well, but conversely, your losses will also be higher. I’ll dedicate an entire coming article to this principle.

For the time being, you should know that the Three-Fund portfolio centers around this idea of risk-adjusted returns. Historically speaking, the overall US and international stock markets have done well, providing consistent returns in the long run. However, when you compare these historical returns to the returns of individual stocks, you may find that these markets have been outperformed by many, many companies, and at the same time, have outperformed many other companies. In short, this portfolio gives up the potential for massive, short-term exponential gains for (historically speaking) less volatile, long-term growth.

In short, the Three-Fund portfolio has a number of elements that can be perceived as both an advantage and a disadvantage; it is ultimately up to you to decide whether you believe certain elements align with your investing strategy. If you're a hands-on investor and have high conviction in certain sectors, perhaps the Three-Fund portfolio isn’t ideal for you. However, if you’re more of a hands-off, “lazy investor”, perhaps this strategy is something to consider. This strategy isn’t necessarily good or bad - its viability depends on your personal goals and beliefs. I hope this article helped lay out some of the different components of the three-fund portfolio. Thanks for reading and I'll catch you in the next one!

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