For most people, investing for retirement means building a
portfolio of index funds or exchange-traded funds (ETFs). Choose the right
funds, and you get excellent diversification and ultra-low costs.
But how many funds do you need in your retirement account?
For many retirement investors, a three-fund portfolio is sufficient. If you’re
feeling like a minimalist, you can get the job done with two funds—or, if
you’re feeling very Marie Kondo, even just one single, solitary fund.
How to Choose Funds for Retirement
Building a well-diversified investment portfolio is job one
for retirement investors. When you choose mutual funds and index funds in your
retirement account, the funds may contain hundreds or even thousands of
individual stocks. On its face, this appears to provide excellent
diversification.
Owning too many funds or the wrong sorts of funds, however,
could result in yet another problem: Overlapping holdings. While you might have
10 index funds or ETFs in your portfolio, all 10 funds themselves could end up
owning substantially similar assets if you’re not careful. (That’s why some of
the best robo-advisors hold just four or five funds in their portfolios.)
As you consider which funds to add to your retirement
portfolio, consider how each fund complements your other holdings. This is the
real key to building a properly diversified retirement portfolio. The ETFs and
mutual funds you own should coordinate with one another in the service of your
investing goals.
The right way to choose is to opt for funds that concentrate
on different asset classes, such as a diversified stock fund, a total market
bond fund and perhaps an income investing option. Passively managed index funds
are your go-to choice because they offer the lowest costs—that is, expense
ratios—on the market.
How Many Funds Do You Need?
You can build a perfectly well diversified retirement
portfolio with three, two or even just one fund. These compact approaches to
retirement investing aim to provide you with the right kind of diversification,
very low costs and simplicity, which could be their greatest advantage.
The two- and three-fund options require minimal upkeep
besides occasional rebalancing. The one-fund option requires practically zero
input from you.
A Three-Fund Portfolio
A three-fund portfolio is made up of three index funds or
ETFs. Advisors typically suggest choosing a total U.S. stock market index fund,
an international stock fund and broad market bond fund. The amount of money you
allocate to each fund depends on your age, goals and risk tolerance.
Stocks have delivered better returns than bonds and cash
over the long term, as you can see from our analysis of the historical
performance of stocks and bonds. Since the beginning of the Great Depression in
October 1929, the annualized return for U.S. stocks has been around 9.6%.
Meanwhile, bonds have provided annualized returns of 5.6% over the same period.
Younger people and more risk tolerant investors should
overweight the total stock market fund in this three-fund model while older,
more risk averse investors would do better to put more money into the broad
market bond fund. Adding an international stock fund that invests in both
developed and emerging markets can provide additional growth that’s potentially
uncorrelated with the U.S. stock market.
To sum up, in a three-fund portfolio you get growth from
stocks, stability from bonds and additional protection from international
stocks.
A Two-Fund Portfolio
Investing legends John Bogle and Warren Buffett have both
advised that a two-fund portfolio is best for many, if not most, investors, and
they agree that the best way to build a two-fund portfolio is to choose a U.S.
equity fund and a U.S. bond fund. They differ on the particulars of the asset
allocation, however.
“Deep down, I remain absolutely confident that the vast
majority of American families will be well served by owning their equity
holdings in an all-U.S. stock-market index portfolio and holding their bonds in
an all-U.S.bond-market index portfolio,” Bogle wrote in “The Little Book Of
Common Sense Investing.”
A total U.S. stock market index fund and a total U.S. bond
index fund would meet Bogle’s parameters, although he also suggested an
intermediate-term bond index fund or an intermediate municipal bond fund could
be used for the fixed income fund option.
Warren Buffett has suggested a two-fund portfolio consisting
of a 90% allocation to an S&P 500 index fund and a 10% allocation to U.S.
treasury bills. Buffett made the advice in one of his letters to Berkshire
Hathaway shareholders, indicating that this two-fund approach was how he would
advise his trustee to invest money for his spouse upon his passing.
“My advice to the trustee could not be more simple: Put 10%
of the cash in short-term government bonds and 90% in a very low-cost S&P
500 index fund,” wrote Buffett. “I believe the trust’s long-term results from
this policy will be superior to those attained by most investors—whether pension
funds, institutions or individuals—who employ high-fee managers.”
A One-Fund Portfolio
There’s another name for a one-fund portfolio you may
already be familiar with: a target-date fund. When you own a target-date fund,
you get an entire retirement portfolio in a single fund. Instead of buying
individual stocks or bonds, it buys a broad portfolio of different mutual
funds—a so-called fund of funds.
Named for the year when you plan to retire, target date
funds adjust their holdings from higher-risk growth assets like stocks to
safer, lower-risk assets like fixed income as the date on the fund approaches.
This mimics the advice you’ve heard before: Younger retirement investors should
own a greater proportion of stocks, shifting the allocation to bonds as they grow
older, to preserve capital and generate income.
Once you choose a target date fund, all you have to do is
set up automatic contributions and the fund managers handle everything else.
They periodically rebalance the fund portfolio to make sure it adjusts to the
right mix of stocks and bonds for where holders are in relation to retirement.
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