When it comes to choosing investments for your 401(k), the sheer number of options available can be overwhelming. There are, however, a number of relatively simple investment strategies that you can use to get the most out of your 401(k). 

One strategy is to invest in a target-date fund, which will automatically optimize your portfolio for retirement on a certain date. Another slightly more complicated approach is to build a 3-fund portfolio.

With the 3-fund approach, you’ll have to do a little more research to find suitable funds, but you’ll have more control than you would with just a target-date fund. In this article, we’ll explain what a 3-fund portfolio is, how it works, and about some of its key benefits.

What Is a 3-Fund Portfolio?

The idea of a 3-fund portfolio prioritizes diversification, a fundamental concept of investing.

However, this approach also provides simplicity for average investors managing their 401(k)s. A 3-fund portfolio focuses on three fundamental asset classes: domestic (U.S.) stocks, international stocks, and domestic bonds. Major brokers offer mutual funds that provide exposure to each type of asset. 

Investors can then determine the best allocation of funds focused on each asset class based on their investing horizon. For example, you may have a portfolio made of 90% stocks and 10% bonds, or vice versa.

U.S. stocks tend to offer the potential for higher returns over the long term, but they also carry more risk, so younger investors may want to allocate more funds to them.

Pros and Cons of a 3-Fund Portfolio

When it comes to managing the investments in your 401(k), you may have to compromise between simplicity and control. While a target-date fund requires less effort with making investing decisions, you will lose some freedom in your investment choices. On the other hand, you could carefully research and manage each aspect of your portfolio, choosing individual stocks that you think will increase in value, but you will likely have increased risk. 

A 3-fund portfolio offers a mid-point between these approaches. It gives you most of the diversification of a target-date fund, while also allowing you to tailor your investments to your needs.

One example of this is the asset allocation in your portfolio. If you are in your 20s or 30s and put all your 401(k) money in a target date fund tied to your expected retirement age, you may start with 90% of your assets invested in stocks and 10% invested in bonds. By the time you reach your 50s, the same target-date fund may have 40% or more invested in bonds, which can reduce your returns just before you reach retirement. By managing your own portfolio, you can manage your own risk.

As with any approach to investment, there are also downsides to the 3-fund portfolio. By choosing just three assets classes, you miss out on wider diversification with other asset types like real estate assets or gold. Another drawback is that you’ll be responsible for some management, such as making sure you have the right mix of bonds and stocks. Whereas target-date funds have automated re-balancing.

Building a 3-Fund Portfolio

If you decide to use a 3-fund approach for your 401(k) portfolio, you have two main decisions to make. First, you need to determine your asset allocation ratios. Then, you’ll need to choose the exact funds for three basic asset categories.

Asset Allocation

Your asset allocation is how you divide up your asset types to manage risk and return potential that suits your goals. With the 3-fund approach, you allocate a certain percentage of your portfolio to one of three types assets: U.S. stocks, international stocks, and bonds. 

Consider your risk tolerance and your investing horizon when you choose your allocation mix. Younger investors usually have a higher risk tolerance because they have a longer investing horizon, so they can whether the ups and downs of the market. So, younger investors may want to invest more heavily in aggressive assets like stocks.

Older investors, including those near or in retirement, tend to prioritize capital preservation. So they may want a higher proportion of low-risk assets like bonds to protect the funds they need to use for living expenses.

Choosing Your Funds

The final step in building a 3-fund portfolio is to decide on specific funds. Generally, you should look for funds that have low costs and that are well-diversified. All of the major brokers have funds that represent each of the basic types of assets, so you can build a 3-fund portfolio through just one broker, or spread your investments across multiple brokers.

For example, you may have a portfolio with these three Vanguard mutual funds:

• Vanguard Total Stock Market Index Fund (VTSAX) 
• Vanguard Total International Stock Index Fund (VTIAX) 
• Vanguard Total Bond Market Fund (VBTLX)

You can also use exchange-traded funds (ETFs) to invest in the asset types. A similar portfolio would include:

• Vanguard Total Stock Market ETF (VTI) 
• Vanguard Total International Stock ETF (VXUS) 
• Vanguard Total Bond Market ETF (BND)

Shop around for the right funds for your needs and consider consulting a financial advisor for guidance on aligning your portfolio with your investing goals.

The Bottom Line

A 3-fund portfolio is an approach to portfolio management that focuses on using three funds to invest in three asset types, typically U.S. stocks, international stocks, and bonds. This strategy is popular among the Boglehead community, who follow investing principles championed by Vanguard founder John Bogle.

You can use a 3-fund approach in most 401(k) accounts, depending on if your employer offers funds to represent each asset type. You will need to decide on the three funds to use and their allocation in your portfolio.