What is the 3-fund portfolio?
The 3-fund portfolio is a portfolio modelled on the idea of maximizing simplicity, diversification, and flexibility. The simplicity allows you to understand and manage your own investments. The diversification helps you lower the risk of any single asset’s underperformance becoming catastrophic. The flexibility enables you to set an allocation that suits your circumstances and financial stage of life.
The three-fund portfolio, which is often recommended for and by Bogleheads, consists of
- A domestic “total market” stock index fund;
- An international “total market” stock index fund; and
- A “total market” bond index fund
With just three funds, you can
- Have a globally diversified equities portfolio;
- Control your level of market risk with your stock to bond allocation; and
- Control your currency risk with your domestic to international allocation,
The Australian version
The Australian version is
Unfortunately, VGS is not a “total market” international fund. It is missing:
Emerging markets are an excellent diversifier of risk, but there are arguments for and against small caps, so for simplicity, I’m going to leave it out, but feel free to include it. So, this leads us to a 4-fund portfolio.
There is one more problem which is concentration risk.
Americans can get away with overweighting their home country’s equities because their market is incredibly diverse. Lowering ex-US stocks has shown to be sub-optional, but it is still a great option.
In contrast, the Australian market is incredibly concentrated, with half the entire value in 10 companies and 2 sectors.
To overcome this, you can lower the amount of VAS (max of 20 or 30% is my preference), but then a high percentage of your assets are exposed to currency risk. To overcome this, you can switch out some of your VAS for VGAD, which is an AUD-hedged version of VGS, so that you’re still globally diversified but with less currency risk.
This leads to a 5-fund portfolio.
|AUD based equities|
|VGAD||(Developed world ex-Australia equities – hedged to AUD)|
|Non-AUD based equities|
|VGS||(Developed world ex-Australia equities)|
|VAF||(Aggregate bond fund)|
A simpler option
While this isn’t overly complex, it’s not quite as simple as using 3 funds. One option for simplicity is a 2-fund portfolio of VDHG and a bond fund. VDHG includes all of the above asset classes and small caps in one fund, and if you’re happy with the proportions, it’s a great solution to keep things simple yet flexible. More info to help decide whether VDHG suits you is available here.
For more in-depth information explaining the fundamental concepts of passive investing expanding on the above allocation and guides on how to determine proportions to suit you, the first section of this site should be useful, particularly articles 1-12.
This is also worth a read.
Thoughts on Australian portfolio construction – Bogleheads