For many years after Jack Bogle introduced his three total market index funds, Vanguard was the only mutual fund company where total market index funds were available. However, as word spread, Schwab, Fidelity, and a few other companies each introduced total market index funds with similar low costs. Investors are now able to construct The Three-Fund Portfolio with whichever company they prefer.

Your first step when getting started is to decide which funds best suit your needs and wants. I hope you are convinced that three low-cost total market index funds are ideal and usually all you need. It is permissible to add more funds, but recognize that adding funds to your Three-Fund Portfolio will add cost and complexity.

Your second step in designing your Three-Fund Portfolio is to decide your most suitable asset allocation. This is your most important investment decision because, with the exception of the amount you are saving and investing, your asset allocation (i.e., your stock/bond ratio) determines your expected return and expected risk. (Remember that expected risk and expected return go hand in hand: The higher the expected return, the higher the expected risk. The Vanguard table shows the average annual return and the worst single-year return of various stock and bond allocations from 1926 to 2015:

The table clearly shows the importance of our overall stock/bond ratio. A high percentage of stocks in a portfolio is more volatile and thus likely to result in both higher returns and greater losses.

Statistics often conceal more than they reveal. For example, what is not shown in the table is the fact that Bear Markets usually last much longer than one year. Therefore, stocks and bonds may have much worse returns than shown for a single year. For example, in the 2008 Bear Market Vanguard Total Stock Market (VTSMX) declined for 16 long months for a total decline of 50.9%. The fund then took another 37 months to recover to its former value. In the same Bear Market, Vanguard Total International Fund (VGTSX) plunged 58.5%. Meanwhile, Vanguard Total Bond Market (VBMFX) gained + 5% in 2008.

Vanguard has a free Asset Allocation Tool that you can use to help you decide your most appropriate asset allocation between stocks and bonds. This is the link:

https://personal.vanguard.com/us/FundsInvQuestionnaire? cbdInitTransUrl=https%3A//personal.vanguard.com/us/funds/tools

Vanguard also has a relationship with Financial Engines, a company that Nobel Laureate Bill Sharpe founded, and it can create awareness about the inherent risks in your portfolio through the use of Monte Carlo simulations. While the future is uncertain, these simulations can share with you the probabilities of future outcomes so you may make informed decisions about the investment risk you are taking as you travel through time.

The basic rule of thumb is to keep your “safe money” (i.e., money you don’t want to risk in stocks) in high-quality bonds. While this doesn’t give you 100% protection against losses at all times, as you can see in the table above, it has still proven to be valuable advice over time.

Your age in bonds is a good starting point. Using that general rule, a 30-year-old might have 30% in bonds. However, if you want to be more aggressive, you’d have less than your age in bonds; and if you want to be more conservative, you might consider having more than your age in bonds.

The table and the Vanguard Asset Allocation Tool ignore the percentage of your stock allocation that should be invested in international stocks. This is one of the most controversial subjects in investing because of concerns about poor accounting controls and government problems in some foreign countries, lack of transparency, currency exchange risk issues, and other concerns associated with foreign investing. Jack Bogle says he’s fine with 0% international but feels that 20% may be okay for investors who want some international exposure.

No one can forecast the stock and bond markets; nevertheless, we must make a decision. I suggest that for U.S. investors, 20% of your equity (stocks) should be placed in a total international stock index fund like the Vanguard Total International Stock Market Index Fund (VTIAX). My suggested 20% is a compromise between the maximum 20% suggested by Jack Bogle and the minimum 20% recommended by a Vanguard study.

Your third step, after determining your desired asset allocation, is to decide whether to use traditional mutual funds or exchange-traded funds (ETFs). This should not be a difficult decision because it doesn’t make much difference unless you are a trader. (ETFs are traded on the open market.) Traders prefer ETFs because they may easily be traded nearly any time of day. Bogleheads shun day trading. We are stay-the-course investors.

Vanguard ETFs are simply another share class of their mutual funds. They hold the same securities as their corresponding mutual funds and are equally tax efficient. They also have the same expense ratios as Vanguard Admiral shares. I suggest you start your portfolio with Vanguard mutual funds, and if you later change your mind, you may switch to the fund’s corresponding ETFs without tax consequences or other costs. However, the reverse is not allowed (i.e., you cannot switch from Vanguard ETFs to Vanguard mutual funds without selling). Different mutual fund companies will, of course, have different rules.

Your fourth step (if you qualify) is to invest in a tax-advantaged retirement plan.

If you participate in a company retirement plan, you are allowed to make tax-advantaged contributions up to $18,000 annually ($24,000 if age 50 or older). Look first to see if your company plan has a low-cost Target Retirement Fund with a stock/bond mix close to your desired asset allocation. A Target Retirement Fund is an all-in-one fund that automatically adjusts the mix of stocks, bonds and cash according to a selected time frame. These funds automatically rebalance and get more conservative as you age. If you later find that you need to make a change in your fund selection for any reason, there is no tax or penalty for switching to a different fund within most retirement accounts.

It’s important to note that not all Target Retirement Funds with the same year in their name contain the same allocation between stocks and bonds, so it’s important that you “look under the hood” and select the fund that most closely matches your desired asset allocation. When choosing your fund, remember that it’s your desired asset allocation that should be the determining factor, not the date in the fund name.

Retirement funds are designed by company experts. It’s hard to go wrong when putting a low-cost target date fund that’s suitable for your time frame, risk tolerance, and personal financial situation into your tax-advantaged account

If there are no low-cost target funds available in your company plan, look for low-cost index funds. Most company plans offer an S&P 500 Index Fund, which is a suitable replacement for the U.S. Total Market Index Fund. Some company plans offering an S&P 500 Index fund will also offer an Extended Market Index fund. These two funds together, in a ratio of 5:1 (five of the 500 Index to one of the Extended Market), are about the same as a single U.S. Total Market Index Fund.

If your company plan does not have suitable low-cost index funds, invest up to the company match in the best low-cost fund available to get the “free money” and then open an IRA, which offers a much larger selection of low-cost funds with which you can complete your desired portfolio. Young investors should always take advantage of saving in their investment retirement account at a level that triggers the maximum “match” from their employer.

If you do not have a company retirement plan, consider an Individual Retirement Account (IRA). There are two main types: Traditional and Roth. Contributions to a Traditional IRA are deductible on your taxes but taxable when withdrawn. Contributions to a Roth IRA are not deductible, but withdrawals are tax free. If you expect to be in a higher tax bracket in retirement, and do not need the tax deduction now, it is usually better to choose the Roth. One advantage of a Roth IRA is that contributions may be withdrawn at any time without tax or penalty. Nearly all mutual fund companies (and banks) will be happy to open an IRA for you.

IRAs can be complicated, but for most of us it boils down to a decision whether to use a Traditional IRA or a Roth IRA. This is a general rule:

• Use a Traditional IRA if you think your income tax rate is higher now than it will be in retirement.
• Use a Roth IRA if you think your income tax rate is lower now than it will be in retirement.

If you want more detailed information, use this link to the IRS website: “Individual Retirement Arrangements (IRAs)”:

https://www.irs.gov/retirement-plans/individual-retirement- arrangements-iras-1

If you are not eligible for a tax-advantaged retirement plan because you have no earned income, or if you have maxed out your retirement plan(s), or if for some other reason you are not eligible, don’t despair. A low-cost, broad-market equity index fund or an ETF is very tax efficient. A taxable account has the advantage of liquidity. You may take your money out anytime, for any reason (although capital gains taxes may be due).

There is one overriding rule when selecting funds or ETFs for taxable accounts: In taxable accounts, use only tax-efficient funds.This is because, if you later sell or exchange a taxable fund that is profitable, it usually triggers a capital gains tax. Total Stock Market and Total International Stock Market funds are excellent tax-efficient funds for taxable accounts when tax-advantaged accounts are full or unavailable.

The Total Bond Market Fund is not tax-efficient and should normally be placed in a tax-advantaged account. If you don’t have space for all of your bonds in your tax-advantaged accounts, consider a high quality tax-exempt intermediate-term bond fund, such as Vanguard’s Tax-Exempt Intermediate-Term Bond Fund (VWIUX), for your taxable account. And, if you are in a higher tax bracket and live in a state with an income tax, a state-specific tax-free bond fund should also be considered for your taxable account.

Morningstar has a free Tax-Equivalent Yield Calculator to help you determine whether to use a taxable or tax-exempt bond fund:

http://screen.morningstar.com/BondCalc/BondCalculator_TaxEquivalent.html

In a nutshell, here is my advice on fund placement for maximum tax efficiency: Place the Total Bond Market Fund in tax-advantaged account(s). If full, use a tax-exempt bond fund in a taxable account. Place the Total Stock Market and the Total International Stock Market Funds in either a tax-advantaged account (best) or a taxable account.

Your fifth step is implementing your plan.

Let’s review:

• Step 1: You have selected three total market index funds or substitute funds.
• Step 2: You have determined your all-important asset-allocation plan.
• Step 3: You have decided whether to use mutual funds or ETFs.
• Step 4: You have selected the best type of account(s).
• Step 5: Now it is time to implement your plan.

At the time of writing, Fidelity and Schwab are in a low-cost bidding war with Vanguard. The result is that a select few of their total market index funds are as cheap or cheaper than Vanguard (by 0.01%). Assuming Fidelity and Schwab maintain very low expense ratios (ERs) in their total market index funds, this is good news for investors. (Be sure to check the fine print, to be certain that what appears in an ad is not just a single “loss leader” designed to bring you in as a client.)

I suggest that you consider Fidelity, Schwab, or Vanguard or any other company offering total market index funds with low expense ratios. A few basis points (a “basis point” is 1/100 of one percent) is less important than a company’s strength, reputation and service. Simply contact the company for instructions on how to get started with your new target fund or The Three-Fund Portfolio:

Contact Information

If your current securities are in a tax-advantaged account, you should be able to exchange your existing portfolio for a Three-Fund Portfolio without any tax consequences.

If your current securities are in a taxable account, and if they’re profitable, you need to consider any resulting taxes and fees before selling existing securities. This is a common problem and is the reason it is so important for investors to use tax-efficient funds when investing in taxable accounts. Here are five steps to minimize taxes:

1. Stop making contributions into unwanted and tax-inefficient securities.
2. Stop reinvesting distributions.
3. Determine the amount of gain or loss in each taxable security.
4. If any security has a loss, consider selling and taking the tax-loss benefit.
5. If any security has a profit, consider selling up to the amount of your losses (after being held for one year to benefit from the lower capital gains tax rate).

Numbers 4 and 5 will be a wash and will result in zero tax. Put the proceeds from your sales into the appropriate tax-efficient total market index fund(s).

Before selling your remaining securities, you have a decision to make: whether to continue holding the tax-inefficient securities you don’t want, or bite the bullet, pay the tax and begin to enjoy a less-costly, simpler, more tax-efficient portfolio using total market index funds.

Caveat: Older investors should keep in mind that under the 2018 federal law, the estate and gift tax exemption is $5.60 million per individual (double for spouses filing a joint return). For this reason, elderly or sickly investors should avoid selling securities with large capital gains, because taxes on the sale of these securities, after death, will be eliminated.

Once you have decided to sell unwanted securities, you must then consider the type of account in which to place your new holdings. If possible, it is almost always better to place your entire Three-Fund Portfolio in tax-advantaged accounts (except for short-term cash needs). However, if your 401k, 403b, IRA or other tax-advantaged accounts have been funded to the legal limit, you must then utilize a taxable account.

If you have questions on fund placement that I have not answered, please post them on the Bogleheads forum at www.bogleheads.org, where amateur and professional Bogleheads will be happy to help you.