Define the three fund model
A three fund portfolio consists of a domestic equity index fund, an international equity index fund, and a fixed income index fund. The model relies on broad market exposure, low expense ratios, and a static allocation framework that can be adjusted for risk tolerance. The underlying premise is that diversification across asset classes reduces unsystematic risk while preserving exposure to market returns.
Assumptions and risk profile
The analysis assumes the investor has a long time horizon (at least ten years), a taxable or tax‑advantaged account, and an ability to tolerate short term volatility in exchange for higher expected returns. The model also presumes access to no‑load, expense ratio below ten basis points for each fund. If any of these conditions are not met, the recommended allocation may need modification.
Select the domestic equity fund
The domestic equity component captures the total market of United States equities. A typical proxy is a total market index fund that tracks the performance of all publicly traded U.S. companies, weighting each by market capitalization. According to Vanguard, such a fund provides exposure to large, mid, and small cap stocks and has historically delivered an average real return of approximately four point five percent per year over the past three decades.
Key criteria
Choose a fund that meets the following criteria: expense ratio under ten basis points, replication method (physical or synthetic) that matches the index closely, and a fund size sufficient to ensure liquidity. Funds that do not meet these criteria may introduce hidden costs that erode the expected return.
Select the international equity fund
The international equity component adds exposure to non‑U.S. markets, reducing concentration risk. An appropriate proxy is a global ex‑U.S. total market index fund, which includes both developed and emerging market equities. Historical analysis by Morningstar shows that adding international equities to a U.S. only portfolio can improve risk‑adjusted returns by roughly one percent per year, measured by the Sharpe ratio, when the correlation between the two markets averages around point six.
Key criteria
Similar to the domestic fund, prioritize a low expense ratio, comprehensive market coverage, and adequate liquidity. Be aware that some international funds may impose foreign tax withholding that reduces net returns for taxable accounts.
Select the fixed income fund
The fixed income component provides stability and income. A total bond market index fund that tracks the Bloomberg U.S. Aggregate Bond Index is commonly used. This index includes government, corporate, and mortgage‑backed securities, covering the full spectrum of investment‑grade credit. The average annual nominal return for this index over the last twenty years has been about three point two percent, with a standard deviation of roughly four percent, considerably lower than equities.
Key criteria
Expense ratio under ten basis points, broad credit exposure, and a duration that matches the investor’s time horizon are essential. If the investor is sensitive to interest rate risk, a shorter duration fund may be preferable.
Allocate percentages
Determine the proportion of the portfolio to allocate to each fund based on risk tolerance. A common guideline is to allocate a percentage equal to (100 minus age) to the combined equity portion and the remainder to bonds. Within equity, a split of roughly seventy percent domestic and thirty percent international is typical. For example, a thirty‑five year old with a moderate risk profile might use the following allocation:
Domestic equity: forty five percent
International equity: twenty five percent
Fixed income: thirty percent
These figures are illustrative; investors should adjust them if their personal circumstances differ.
Implement the portfolio
Open an account with a brokerage that offers the selected funds without transaction fees. Deposit the total capital, then place purchase orders for each fund in accordance with the target percentages. Many platforms allow the investor to set the exact dollar amount; rounding differences of a few dollars are acceptable and do not materially affect the outcome.
Maintain and rebalance
Over time, market movements will cause the actual weights to drift from the target allocation. Rebalancing restores the intended risk profile. A practical rule is to review the portfolio quarterly and execute a rebalance when any fund deviates by more than five percent from its target weight. Rebalancing can be performed by selling overweight positions and buying underweight positions, or by directing new contributions to underweight funds, which reduces transaction costs.
Edge cases include investors with tax‑sensitive accounts where selling appreciated assets triggers capital gains. In such situations, consider using tax‑loss harvesting or adjusting the rebalance threshold to minimise taxable events.
Finally, periodically reassess the core assumptions: changes in investment horizon, risk tolerance, or the availability of lower cost funds may warrant a revision of the allocation.
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