With the S&P 500 trading near record highs, many investors are questioning whether it's the right time to enter the market. The fear of a potential downturn can lead to indecision, but financial experts often advise that consistent investing, rather than attempting to time the market, is a more reliable path to building wealth. A straightforward strategy using just three low-cost exchange-traded funds (ETFs) can offer a diversified and resilient foundation for any portfolio.
This approach focuses on capturing broad market returns from the U.S., international stocks, and bonds, creating a balanced portfolio designed to weather various economic conditions. By using core ETFs, investors can achieve global diversification with minimal complexity and low management fees, allowing their investments to compound over time without the stress of picking individual stocks.
Key Takeaways
- A three-fund portfolio provides broad diversification across U.S. stocks, international stocks, and bonds.
- This strategy is built on low-cost index ETFs, minimizing fees that can erode long-term returns.
- It is designed to be a long-term solution that reduces the need for market timing or individual stock selection.
- The allocation can be adjusted based on an individual's age, risk tolerance, and financial goals.
The Foundation: Capturing the U.S. Market
The first component of this strategy is a comprehensive U.S. stock market fund. While many investors equate "the market" with the S&P 500 index, a total stock market fund offers even broader exposure.
An ETF like the Vanguard Total Stock Market ETF (VTI) holds not just the 500 large-cap companies in the S&P 500, but thousands of stocks, including mid- and small-cap companies. This provides a more complete representation of the entire U.S. equity landscape.
Vanguard Total Stock Market ETF (VTI) at a Glance
- Holdings: Over 3,500 individual U.S. stocks.
- Expense Ratio: Approximately 0.03%.
- Focus: Market-cap-weighted exposure to the entire U.S. stock market.
Despite its breadth, this type of fund is still heavily weighted toward large technology companies like Microsoft, Apple, and Nvidia, similar to the S&P 500. However, by including smaller companies, it captures growth potential from all corners of the economy. The extremely low expense ratio means that costs do not significantly impact investment returns over the long term.
Expanding Horizons: Global Diversification
Investing solely in the U.S. market means missing out on opportunities in the rest of the world. The second pillar of the portfolio is an international stock fund, which adds geographic diversification and can help smooth out returns when the U.S. market underperforms.
The Vanguard Total International Stock ETF (VXUS) is an example of a fund that invests in a wide array of non-U.S. companies. It covers both developed and emerging markets, offering exposure to thousands of companies across Europe, Asia, and other regions.
Why International Exposure Matters
Different countries and regions experience economic cycles at different times. Holding international stocks can provide a buffer when the U.S. economy slows down. It also allows investors to participate in the growth of global economies that may be expanding at a faster rate.
This fund holds approximately 8,700 stocks, providing a vast and diversified basket of global equities. Its portfolio is geographically distributed, with Europe making up the largest portion at nearly 38%, followed by emerging markets at around 28% and Asia at about 25%.
The expense ratio for such a fund is typically slightly higher than its U.S. counterpart, around 0.05%, due to the increased complexity and cost of trading across multiple international markets. However, this remains a very low fee for such extensive global access.
The Stabilizer: The Role of Bonds
The final piece of the puzzle is a bond fund, which serves as a stabilizing agent in the portfolio. While stocks provide the primary engine for growth, bonds tend to be less volatile and often perform well when stocks are declining. This inverse relationship helps cushion the portfolio during market downturns.
For simplicity and safety, a high-quality U.S. bond fund is often recommended. The Vanguard Total Bond Market ETF (BND) invests in a broad mix of taxable, investment-grade U.S. bonds, including government and corporate debt.
This fund provides stability and income, which are the traditional roles of fixed-income assets in a balanced portfolio. With an expense ratio of just 0.03%, it is a cost-effective way to reduce overall portfolio risk.
"Bonds are generally used to provide stability to a portfolio when using an asset allocation framework. While the stock ETFs are the exciting growth stories, the bond ETF you buy should, almost literally, lull you to sleep."
While investors could explore international bonds, the complexities of currency fluctuations and varying credit risks make a U.S.-focused bond fund a more straightforward and often safer choice for the core of a portfolio.
Constructing and Maintaining Your Portfolio
With these three building blocks, an investor can create a globally diversified portfolio. The next step is to determine the allocation, or how much to invest in each fund.
A Classic Starting Point
A traditional starting point for asset allocation is the 60/40 portfolio, which consists of 60% stocks and 40% bonds. This has long been considered a balanced approach for moderate-risk investors. Younger investors with a longer time horizon might choose a more aggressive allocation, such as 80% or even 90% in stocks, while those nearing retirement may prefer a more conservative mix with a higher allocation to bonds.
The 60% stock portion can be further divided between U.S. and international funds. A common approach is to overweight the home market, for example, by putting 40% in the U.S. stock fund and 20% in the international fund. However, an equal split is also a reasonable strategy.
The Importance of Rebalancing
Once the allocation is set, it is important to maintain it. Over time, the best-performing assets will grow to represent a larger portion of the portfolio. To bring the portfolio back to its target allocation, investors should rebalance periodically, typically once a year. This involves selling some of the assets that have performed well and buying more of the underperforming ones.
This disciplined process ensures the portfolio's risk level remains consistent with the investor's goals. By focusing on this long-term strategy, investors can build a robust portfolio designed to function through market cycles, regardless of what happens in any single year.
