Can You Get It Done With 3 Funds?

by: Roger Nusbaum

The Wall Street Journal brought back around the idea of a three fund portfolio consisting of a broad based domestic equity fund, a broad based foreign equity fund and a domestic, aggregate bond fund. It is a very simple concept and of course, like any strategy, it can work for someone with the right temperament. When foreign outperforms domestic then the equity portion will outperform the S&P 500, and with a run like we've had over the last year or so, where foreign lags, then the equity portion will underperform the S&P 500.

The duration of most aggregate bond funds is not too far out, but they definitely are not immune to rising rates. These funds should not get crushed, relatively, if rates actually return to normal levels but they will go down. The yields will never be fantastic relative to prevailing rates but they'll be okay. Anyone looking to live off of dividends and/or interest will be living on a low payout rate; in the twos right now.

Most broad foreign funds don't have much in the way of emerging market exposure, they tend to be dominated by larger markets like developed Europe and Japan. Obviously emerging markets have had a terrible year so far, but at some point in the future they will, of course, rotate back into favor for one reason or another and become white hot performers again.

In using a broad domestic fund, the next time a sector grows disproportionately large within the index like tech in 2000 and financials in 2007, then any broad based domestic index fund used in this strategy will suffer whatever the consequence might be. The above is not offered to talk anyone out of doing this strategy but to point out the drawbacks going in. Any idea for a portfolio will have drawbacks. This would not be a good portfolio for someone wanting to take 4% out in dividends, for example.

Success with this portfolio would come from having the discipline to rebalance when it is uncomfortable to do so, accepting there will be good things that happen in the market that will be missed and, more than anything else (in my opinion), success relies on essentially being an emotionless robot when it comes to the portfolio. Maybe better than emotionless robot would be never, I mean never, succumbing to emotion. Investors don't get into trouble for having emotions, they get into trouble succumbing to them.