Investing doesn’t have to be complicated.
I’ve spent twenty years studying the financial markets. I majored in finance and worked as a trader at a major Wall Street investment bank.
After all these years following the market, I’ve concluded that the best portfolio for the average investor isn’t some complicated trading strategy or a mix of high-cost actively managed mutual funds.
No, it is actually a diversified mix of low-cost index funds. I especially like the three-fund portfolio.
Vanguard is the largest index fund manager in the world. While there are other excellent index fund managers (e.g. Fidelity, Schwab) that offer funds with low expense ratios (ER), Vanguard remains the gold-standard in index fund management.
In this article, I will help you build a portfolio of index funds with Vanguard. We’ll start with a simple portfolio (just one-fund!). Then we’ll slowly add funds based on how complex (which is not necessarily better) you want your portfolio to be.
One-Fund Portfolio: U.S. Stocks
Legendary investor Warren Buffett has repeatedly written that the average investor should invest their money in a S&P 500 fund. The S&P 500 is composed of the 500 largest publicly-traded U.S. companies. You can invest in the S&P 500 at Vanguard with the Vanguard 500 Index Fund (VFIAX, ER = 0.04%) or Vanguard S&P 500 ETF (VOO, ER = 0.03%). By investing in the S&P 500, you’ll get the market return that most investors try (and typically fail) to beat.
However, since the S&P 500 index only contains large-cap stocks, I prefer the Vanguard Total Stock Market Index Fund (VTSAX, ER = 0.04%) or Vanguard Total Stock Market ETF (VTI, ER = 0.03%), because it gives you ownership of small-cap and mid-cap stocks in addition to large-cap stocks. By investing in more than 3,500 stocks, the Vanguard Total Stock Market Index fund provides a more diversified portfolio than the S&P 500 portfolio.
Two-Fund Portfolio: Add U.S. Bonds
For many investors, especially young investors, the one-fund portfolio is all you need. But since U.S. stocks are very volatile, most investors will want to add some bonds to their portfolio. Bonds are much less volatile than stocks, and they often move in opposite directions as stocks (including during the 2008 financial crisis). The Vanguard Total Bond Market Index Fund (VBTLX, ER = 0.05%) or Vanguard Total Bond Market ETF (BND, ER = 0.04%) is a great way to purchase the U.S. bond market. By investing in over 8,500 corporate and U.S. government bonds, this index fund gives you a broad, diversified portfolio of U.S. bonds.
Three-Fund Portfolio: Add International Stocks
With just two funds, you have now invested in the entire U.S. economy. This is a great portfolio for many investors. But since the U.S. economy is only a fraction of the global economy, you can increase diversification by adding an international stock market index fund. The Vanguard Total International Stock Index Admiral Shares (VTIAX, ER = 0.11%) or Vanguard Total International Stock ETF (VXUS, ER = 0.09%) gives you broad exposure to both developed international stock markets (such as Europe and Japan) as well as emerging markets (such as Latin America, Russia, and China).
Adding a third fund to your portfolio is completely optional; Vanguard founder Jack Bogle doesn’t invest in international stocks.
Four-Fund Portfolio: Add International Bonds
The three-fund portfolio is a very popular portfolio. I don’t purchase any additional asset classes beyond U.S. stocks, international stocks, and U.S. bonds. However, some investors may be interested in more complicated portfolios.
The next fund I would add to your portfolio is international bonds. International bonds will not move in lock-step with the U.S. bond market, so you can increase the diversification of your portfolio by adding a fourth index fund. The Vanguard Total International Bond Index Fund (VTABX, ER = 0.11%) or Vanguard Total International Bond ETF (BNDX, ER = 0.08%) is an excellent low-cost way to get exposure to the international bond market. It contains over 4,200 international bonds, including bonds from foreign governments and international corporations. The index contains bonds from both developed and emerging markets.
Five-Fund Portfolio: Add REITs
With a four-fund portfolio, you now have exposure to the entire global stock and bond market. If purchased in the correct proportions, you can replicate Vanguard’s Target Retirement Funds. Creating your portfolio this way will be cheaper than purchasing the Target Retirement Fund directly from Vanguard.
However, there are alternative asset classes that don’t move with either the stock or bond markets. Because of their low correlation to stocks or bonds, adding these alternative asset classes can further increase the diversification of your portfolio.
The most popular alternative asset class is real estate. Many investors who do not invest directly in real estate will nevertheless have exposure to real estate prices through the ownership of their primary home. You can invest in real estate by purchasing individual investment properties, but this would be like investing in just a single stock. To get broad exposure to the real-estate market with an index fund, you can purchase the Vanguard REIT Index Fund (VGSLX, ER = 0.12%) or Vanguard REIT ETF (VNQ, ER = 0.12%).
Summary
Here are the five portfolios, in order of complexity. Remember that Admiral Shares have a $3,000 minimum investment, so if you want to invest less than that in a particular index fund, purchase the equivalent exchange-traded fund (ETF) instead, which has no minimum investment.
| Portfolio | Admiral Shares | ETF |
| One-Fund: Start with U.S. Stocks (S&P 500) | VFIAX | VOO |
| One-Fund: Start with U.S. Stocks (Total Stock Market) | VTSAX | VTI |
| Two-Fund: Add U.S. Bonds | VBTLX | BND |
| Three-Fund: Add International Stocks | VTIAX | VXUS |
| Four-Fund: Add International Bonds | VTABX | BNDX |
| Five-Fund: Add REITs | VGSLX | VNQ |
That’s how you create a diversified index fund portfolio using Vanguard mutual funds. As Steve Jobs would say, “It’s that easy.” You can start with the Vanguard 500 or Vanguard Total Stock Market Index and gradually add funds as you read and learn more about investing. You don’t need to have a degree in finance or Wall Street trading experience to do this. With any of the portfolios I described above, you’ll likely beat the majority of the fund managers on Wall Street.
What do you think? Do you use Vanguard index funds in your portfolio?
I primarily just stick with index ETF’s. Don’t see the point because I don’t think many Vanguard funds beat the index in the long run.
On the otherhand, I am thinking of investing some money into DAX etf’s.
Mutual funds or ETFs are excellent options to form a low-cost index fund portfolio.
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Looks about right. We have a similar situation to the five fund but with a small cap added in. I also split between vanguard and other providers based on the cheaper options at my brokerage. So in one account we hold vanguard but in another were using a Schwab.
Definitely the next layer of complexity with index fund portfolios is the introduction of tilts to small-cap or other asset classes.
Good post. It really is that easy to do this. A little more complicated when your retirement money is in 3 or 4 different accounts, but still pretty easy.
Thanks, WCI. I agree about the multiple retirement accounts, especially when they do not offer Vanguard (or even index fund) offerings.
It is that easy. Great breakdown though that made it look even easier! Lots of people are going to get good ideas from this post WSP!
Thanks BLI. The list of index funds, even at Vanguard, can be overwhelming for many investors, and I really wanted to cut through all of that clutter in this post.
Great summary and I agree it’s that easy. Simplicity allows people to actually just do it.
Thanks, Buck. Sometimes investing, even index-fund investing, can become overwhelming for new investors, so I hope this article will help investors build their index fund portfolios.
The latest vanguard webcast https://personal.vanguard.com/us/insights/article/live-webcast-managing-portfiolio-042017 makes the point that all the REITs are in the total market index, so buying more just overweights you in REITs, and is essentially betting that the market has not correctly valued REITs.
Thank you for sharing that video. They assume that the investor prefers a real estate allocation equal to the allocation of publicly available REITs in the global economy. Just as few investors hold international stocks in its proportion by market cap with us stocks (50/50), adding REITs allows you to tailor your exposure to real estate.
I’d say just go with a balanced fund. Vanguard Wellington is almost as cheap as an index fund. It has great long term returns without crazy volatility. It owns a little bit of international stock. It’s not quite as well diversified as the 3 fund portfolio, but it’s good enough.
I also like:
Mairs & Power Balanced
Dodge & Cox Balanced
Fidelity Balanced
Vanguard STAR
Vanguard Balanced Index
Oakmark Equity & Income
All of the above funds have below average expenses and above average long term returns.
It’s just easier to have it all in one portfolio so you don’t have to think about rebalancing.
Thank you for your comment. There are many ways to invest. I favor a three-fund portfolio. Target-date funds are a good alternative to the three-fund portfolio.
Yes I agree, “perfect” is the enemy of “good enough”.
ETFs’ ER are often lower than that of Admiral Shares for a corresponding fund, but I’m assuming the added commission costs of ETFs negate any benefit to using them as your primary option over Admiral Shares. I’m also assuming that since you recommend ETFs as the next best option to Admiral Shares that they are superior to Investor Shares because, at some point between the ER of ETFs and Investor Shares, the commission costs of ETFs become worth it?
If you purchase Vanguard ETFs in a Vanguard account, there are no commissions. Therefore, I prefer ETFs over the Investor shares for those who cannot contribute the $10,000 minimum for Admiral shares.
If I’m building your three fund portfolio what percentage of my investment money should I put in each fund?
The decision is based on your risk tolerance and preferences. I’ve discussed in other articles how to think about the best stock / bond allocation and domestic / international allocation for you, but there’s no one perfect answer for everyone.
I think gold is really valuable to throw in there too. I’ve run across several bloggers that don’t like gold, but over the past 10 years, the gold etf (GLD) is up 88.68% and Vanguard Total Stock Market Index (VTSAX) is up 75.39%. https://www.google.com/finance?q=vtsax&ei=4y6eWbH7JdWxjAH40rXICQ
Even with the bull market for the past 8 years or so, returns on gold are still ahead… (for a 10 year period, anyway)
I like to think of Stocks, Real Estate, Gold, and Bonds as the Yin/Yang. Greed is stocks and real estate. Fear is Gold and Bonds.
I’m not a big fan of gold, but there are some investors who are “gold bugs.”
WSP, just like in an earlier comment you mentioned that tilting things toward small cap (or value) is often the sixth step, a small allocation to precious metals can work. Gold is volatile, negative correlated to stocks during a crisis (Joe called it fear), and its long term returns have been very close to inflation. That said, I agree with you that precious metals should be a diversifier, and not the core of one’s portfolio.
So, if I am an investor in my mid/late 20s with roughly $20-25k to invest, would it be wise to:
Invest the initial minimum amount in the Vanguard Total Stock Market Index Admiral Shares (VTSAX), and then invest in something like the Vanguard total bond market ETF (BND) to achieve proper asset allocation for the time being since I don’t have enough money to invest in Vanguard Total Bond Market Index Admiral Shares right now? Then, as time goes on and my portfolio builds, consider moving money from the ETF into the Total Bond Market Index Admiral Shares and consider adding in international stocks and bonds?
Thanks for the article and any advice, just a young investor trying to navigate the market!
Great question! I generally don’t investors should have 100% of their money in stocks, so a two-fund portfolio would make most sense for you. For example, you could use a 90/10 stock/bond allocation and have 18k in VTSAX and 2k in BND. You are correct to use BND instead of VBMFX. As you save more and have more money to invest, you could switch to the Admiral shares for your bond allocation (but I would just stay in BND because there is no significant difference between the Admiral shares and ETF at Vanguard), and add international stocks if you want to diversify.
Thanks again for this and your other three fund portfolio posts. Did exactly what you indended, let a novice cut through the clutter.
Due to multiple accounts (vanguard and schwab), I have used these as a guide to build my seven-fund three fund portfolio 😀
Haha, yea with multiple accounts you may end up holding several versions of the same index fund.
WSP,
Other than Expense ratio and commission is there any reason to chose Vanguard Mutual funds over ETF?
Thanks!
Mutual funds don’t have a bid-ask spread (miniscule I know at Vanguard). The ETF and Admiral Shares generally have the same expense ratio at Vanguard, which is lower than the Investor shares.
Great article thank you. In the last 3 years I decided to work on my debt and have paid off 36K with only 13K left (excluding student loans aka Life Debt)in that time. I used the Snow Ball approach which really fit my spending style. Now that my debt accounts are all under 10% interest I feel it makes sense to start investing now and balancing out the money going out to debt without being tight for money. Even though I’m in my early 40’s and starting late, I think I’ll be able to make a few pennies out of it all and be able to leave something behind for my son. I did start a 529 plan for him when he was born and already made 1k on it in 2 years. While other sites have spoke of many options you narrowed it down for me and I will be taking the 3 Fund approach as mentioned with Vanguard. I’d also like to move everything to one location as well like my Roth.
Thanks again,
Dan
Congratulations on the progress you’ve made so far on paying off your debt!
What percent in international stocks and international bonds?
The percentage in international stocks and international bonds is highly personal and part of your asset allocation strategy. Check out this article for my thoughts on international stock allocation.
Are there Fidelity funds that are similar to your above two and three fund suggestions?
Yes, check out my related article on how to build a Fidelity two-fund or three-fund portfolio.
[…] been my article describing how you can build simple index fund portfolios, including my favorite three-fund portfolio, using Vanguard index funds. Using the funds from that article, you can build a diversified […]
What is the percentage allocation for two-fund, three-fund, four-fund, and five-fund?
That is the art of asset allocation. Check out this article for my thoughts on how much to put in stocks vs. bonds, and this article on how much to put in domestic stocks vs. international stocks.
Thanks for this helpful write-up! I unfortunately have not done the smartest thing and have most of my savings in a lowly savings account, but I want to change that! I like this simple portfolio approach but had a question. I plan on joining my company’s 401k and maxing that out. I wanted to then open a Roth IRA and max that out. I would still have money left over (in addition to an emergency fund) so I was also going to open a taxable account. Is it suggested to follow this 3 fund portfolio in each of these accounts (401k, IRA, taxable)? And should I have the same funds in each account? For example, if I have the Total Stock Market index in my IRA, would it be bad to also have it in my taxable account?
Again, thank you for the write-up!
This is a point of significant debate. I personally prefer to keep bonds in retirement accounts, but not in Roth IRAs. Other well-respected finance writers think you should put your bonds in taxable accounts.
You certainly aren’t required to have the exact same allocation in each of your accounts. I certainly don’t. It’s about matching your asset allocation across all your accounts to your preferred asset allocation. It’s OK to have VTSAX in both your taxable accounts and your IRA.
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Other then Admiral Shares having a $3,000 minimum investment, what’s the difference between and benefits of Admiral shares and ETF funds?
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