Benefit 1: No Advisor Risk

The Three-Fund Portfolio is remarkably easy to maintain. For this reason, most three-fund investors can avoid the additional cost and risks of using a broker or a financial advisor.

There are two primary risks when using an advisor: “incompetence” and “conflict of interest.”

Incompetence: In most states, the minimum level of education needed to become a broker or a financial advisor is lower than that needed to become a hairdresser or an electrician. Most states do not require even a high school diploma to become a broker or a financial advisor. Financial advisors are required to take a state licensing exam that tests basic product knowledge and awareness of the applicable state and federal laws. However, none are required to have any substantive or formal education in financial planning itself.

Conflict of interest: You want the lowest cost subtracted from your returns. Your advisor wants the largest income for himself and his family. You can guess who is likely to win.

You must understand that whatever the advisor is paid comes out of the return on your investment. The cumulative impact of advisor and broker fees over an investment lifetime can be huge, as the table below shows.

Advisor costs appear minor and are easily hidden. Several studies have shown that brokers and advisors may actually earn more than their customers. Brokers and advisors can be ethically challenged, and many do not put their clients first. True costs often are hidden in the fine print of statements their clients receive.

On April 14, 2016, the U.S. Department of Labor proposed a fiduciary rule that would require financial brokers to consider their client’s best interest (instead of their own) when offering retirement investing advice. It is not surprising that insurance companies, mutual funds and brokerages, with an army of lobbyists, are vigorously fighting implementation of the fiduciary rule.

I am not saying to avoid all advisors. For those who really need one, a low-cost advisor can be worth the fees charged. A good fiduciary advisor can provide services that many investors may not be able to handle themselves. For example, a good advisor will:

• Help determine your goals and determine how much you’ll need to save to reach those goals
• Help structure your most appropriate asset allocation
• Help you stay the course during Bear Markets
• Help with insurance needs (including life, disability, and health care)
• Give advice about taxes, social security, annuities, tax-loss harvesting, rebalancing, order of withdrawals, estate planning, and other financial matters

If you feel you need the services of an advisor, Vanguard offers a Personal Advisory Service. Their non-commissioned, professional advisors currently charge just 0.3% of assets. Services include an in-depth analysis and assistance in transferring assets. You might also check the website of the National Association of Personal Financial Advisors (www.napfa.org) or the Garrett Planning Network (www.garrettplanningnetwork.com). Both organizations list fee-only planners. Using one of these advisors can be much less expensive than paying a percentage of your assets under management (known as AUM) year after year to a commission-based broker or other financial advisor. You should also check with the Securities and Exchange Commission (www.sec.gov/investor/brokers.htm) for any disciplinary history on the registered advisor you are considering using.

The simple, successful Three-Fund Portfolio, which nearly anyone can manage, will significantly reduce your need for an expensive advisor. Investors seeking more advanced information, often in place of an advisor, should read The Bogleheads’ Guide to Investing and/or The Bogleheads’ Guide to Retirement Planning.

Benefit 2: No Asset Bloat

When a managed fund is flooded with new money, it is very disruptive and usually results in lower returns. This is called “asset bloat.” There are several reasons asset bloat is bad:

• As investors rush into a popular active mutual fund, new cash is disruptive because it requires the fund manager to spend more time with additional security analysis. It also increases the fund manager’s duties, as it is imperative to get the new cash invested as quickly as possible.
• The manager cannot invest large amounts of cash in a company without impacting the market for that company’s stock. This is because a large purchase of company stock will drive up the price of that stock as shares are bought. Market impact is especially true of small-company stocks.
• The fund manager will find it difficult to invest the money in a satisfactory manner because as fund assets rise, the number of appropriate additional stocks shrinks, making it difficult to maintain the fund’s objectives. The fund manager also knows that transaction costs, (e.g., commissions, bid-ask spreads, market impact and opportunity costs) will increase, affecting existing fund shareholders.
• Mutual fund regulations prohibit a fund from owning more than 10% of the outstanding voting shares of an issuer. This restriction may prevent a fund manager from buying more shares of company stock that the fund already owns, thereby forcing managers to buy less-desirable securities.

The Fidelity Magellan Fund is often mentioned as a victim of asset bloat. In 1990, the Magellan Fund was the largest mutual fund in the world. Unfortunately for investors who came in late, its returns subsequently plunged to the bottom 1% of its Morningstar category. The result was that many investors in Magellan lost a large part of their life savings.

Vanguard is known for its willingness to close a fund when that fund becomes bloated. In 2016, Vanguard closed its $30.6 billion Dividend Growth Fund (VDIGX) to new investors. As former Vanguard CEO Bill McNabb explained, “Vanguard is proactively taking steps to slow strong cash flows to help ensure that the advisor’s ability to produce competitive long-term results for investors is not compromised.”

David Swenson, Yale University Chief Investment Officer and author of Unconventional Success, wrote: “Bloated portfolios and excessive fees represent the most visible ways in which mutual fund manager agents extract rents from mutual fund investor principals.”

Total Market Index Funds are not affected by asset bloat because all new money is easily distributed among the stocks of thousands of companies.

Benefit 3: No Index Front Running

“Index front running” is when traders know in advance that an index manager must sell a stock because it no longer meets the index specifications. Perhaps a small-cap stock has grown too large for its small-cap index or a value stock has become a growth stock. In both cases, traders know that the index fund manager must sell one or more of its stocks in that category.

This works the same as when a trader knows in advance that an index manager must buy a stock to meet the index specifications. Advance knowledge normally lowers the price of a stock to be sold and raises the price of a stock before it is bought, to the detriment of both the index fund manager and the fund investors.

In March 2015, American Airlines announced it would be added to the S&P 500 Index. Between the time of the announcement and the time when the company was added to the index four days later, the company stock increased 11%, thereby increasing the cost to the index and ultimately hurting its performance.

A study by Winton Capital Management Ltd. found that the S&P 500 Index lost 0.2 percentage points from 1990 to 2011 due to front running.

Total Market Index Funds do not suffer the impact of front running because they hold nearly every publicly-listed stock. If a stock is sold by a small-cap index and bought by a mid-cap index, it makes no difference to the passive manager of a total market index fund because the index fund manager neither sells nor buys the stock, thus avoiding front running and other hidden turnover costs.

Benefit 4: No Fund Manager Risk

Since Mr. Bogle’s introduction of the first retail index fund, First Index Investment Trust, the financial industry has fought a losing battle, spending billions each year in an attempt to keep investors in expensive and highly profitable (for them) actively managed funds, rather than in low-cost index funds.

A good example of “manager risk” is the Fidelity Magellan Fund (FMAGX), managed by Peter Lynch. Between 1977 and 1990 the fund averaged a 29% annual return, making Magellan the best performing and largest mutual fund in the world.

So, what happened? In 1990 Mr. Lynch decided to retire. A succession of new managers were hired and fired as the Magellan Fund began to underperform the market. Shareholders, many of whom bought near the top, began selling with large losses as the fund’s return declined. On January 12, 2018, the Magellan Fund was in the bottom 11% of all funds in its Morningstar category for 10-year returns.

Bruce Berkowitz, manager of the Fairholme Fund, is a more recent example of fund manager risk. Berkowitz was Morningstar’s “Manager of the Decade” in 2009, but on January 12, 2018, the Fairholme Fund was in the bottom 1% of its category. As of this writing, Mr. Berkowitz remains manager.

Specific Fund Manager Risks

1. Fund managers always leave. In the case of Peter Lynch, it was because he decided to retire. However, fund managers leave for other reasons: sickness, transfer to another fund, a move to another company. Many fund managers are simply fired for underperformance. Total Market Index funds do not have this problem.
2. Winning fund managers later underperform. It seems obvious that a good stock or bond picker should easily outperform an index fund that simply reflects the average stock return. Nevertheless, like Bill Miller and Bruce Berkowitz, whose stories were recounted earlier, most winning fund managers eventually underperform their index benchmark. This is called “Reversion to the Mean.”

Warren Buffett has used the “monkey illustration” to explain why it is impossible to know whether a fund manager has outstanding talent or was just lucky: “If 1,000 managers make a market prediction at the beginning of the year, it’s very likely that the calls of at least one will be correct for nine consecutive years. Of course, 1,000 monkeys would be just as likely to produce a seemingly all-wise prophet.”

Index fund managers make no attempt to pick winning stocks. Their job performance is measured by low cost and by accurately tracking their index.

Benefit 5: No Individual Stock Risk

I remember attending a Miami Herald Money Show in March 2000. Unknown at the time, this was the year and month when the U.S. stock market had reached its peak after a long Bull Market and was about to suffer one of the worst Bear Markets since the Great Depression.

Jack Bogle and Jim Cramer (the financial television personality) were the keynote speakers. Jack spoke first and warned the large audience that the stock market was overvalued, and he reminded them about the importance of holding a substantial allocation of high-quality bonds.

When Mr. Bogle finished speaking, it was Mr. Cramer’s turn. I was standing in the back of the auditorium with Mel Lindauer, my co-author on two other Bogleheads’ books. Jim asked the audience to take out a pencil and paper and write down the names of ten individual stocks he would be recommending as sure “winners.” Mel and I watched as hundreds of naive investors eagerly wrote down Mr. Cramer’s top stock tips. (I couldn’t fault them for effort, since I had once tried this on my own.)

Most of the audience seemed sure they were getting important stock tips from a popular media guru, but the way those tips actually played out was a different story. Four years later, in the April 2004 edition of Barron’s magazine, Alan Abelson wrote, “[Cramer’s] 10 dot com bubble picks of 2000 ended up tanking by an average of 90%.” Picking individual stocks is very risky, as “Jim Cramer’s Top Stock Picks” illustrates.

Unlike mutual funds, individual stocks can plunge to zero. On the 50th birthday of the S&P 500 Index, only 86 of the original 500 companies still remained, showing it is possible to turn a large fortune into a small fortune with individual stocks. On the other hand, it is unheard of for a registered mutual fund to go to zero.

Many investors, especially new ones, attempt to “beat the market” by investing in individual stocks. The temptation is understandable when we read about the fabulous returns (when true) of someone who had the foresight to buy a little-known stock before it became a winner. Stock pickers love to talk about their good stock picks, but they seldom, if ever, talk about their bad ones.

Daniel Kahneman and Amos Tversky suggested in a 1992 study that people dislike losses twice as much as they like gains.¹ The media (to increase viewing and readership) encourage investors to buy individual stocks by featuring recommendations from “experts,” who—more often than not—are proven wrong. We are seldom reminded that many of yesterday’s hot stocks (think Kodak, Enron, General Motors and Westinghouse) have turned from winners to losers, leaving most of their investors suffering large losses.

Benefit 6: No Overlap

“Overlap” occurs when two different mutual funds or ETFs share the same securities in a portfolio. So, if an investor owns multiple mutual funds or ETFs that contain the same securities, the result is a less-diversified portfolio.

To minimize risk, investors want funds with securities that act differently. If one stock or bond fund declines in value, we want other stocks or bonds in the portfolio to gain in value. If two funds hold securities that are the same (i.e., overlapped), diversification is reduced and risk increases.

Many company retirement plans do not offer a Total Stock Market Index Fund. Instead, they offer an S&P 500 Index Fund. That’s a good substitute, since both funds hold the largest and most successful stocks in the United States, and both have similar long-term risks and returns.

Many times, a company, an educational institution, or a government entity will offer a combination of an S&P 500 Index Fund and an Extended Market Index Fund. Investors can achieve a fund similar to a U.S. Total Market Index Fund by using those two funds, combining 80% S&P 500 Fund with 20% Extended Market Fund. There will be no fund overlap, because Mr. Bogle specifically designed the Extended Market Index Fund to complement the S&P fund by avoiding any individual stock overlap.

The more funds in a portfolio, the greater the chance of fund and securities overlap. You’ll be happy to know there is no fund or securities overlap in the Three-Fund Portfolio.

Benefit 7: No Sector Risk

“Market sector risk” is the risk you face when investing in individual sector funds, such as Financials, Healthcare, Real Estate, Energy, Utilities, Gold and Technology, to name a few. The risk is that the sector you choose may perform worse than another sector.

A good example of the risk in sector investing was the popularity of the technology sector in the late 1990s, when technology stocks began to significantly outperform most other sectors. As a result, investors began piling into “hot” technology funds. Unfortunately for them, the tech-heavy NASDAQ Index lost 77.9% during the 2000–2002 Bear Market, thereby wiping out a lifetime of savings for many investors.

Another example of sector risk is Vanguard’s Mining and Precious Metals Fund, originally named “Vanguard Gold Fund,” which has been Vanguard’s most volatile fund. In 1993, Vanguard Gold Fund gained + 93.4%—the best return of any Vanguard fund. Fund assets exploded as investors scrambled to buy shares. Unfortunately for those investors, Vanguard Gold Fund began its “reversion to the mean”, which is what usually happens to top performing funds. By December 2000, Vanguard Gold Fund had the worst 5- and 10-year returns of all Vanguard funds.

There is no reason (except speculation and industry marketing) to add risky sector funds to a portfolio. Vanguard’s two Total Market Equity Funds already contain the market weight of sector funds—and with much less risk, cost and complexity.

Benefit 8: No Style Drift

“Style drift” is the divergence of a mutual fund or an ETF from its stated investment style (focus). Most investors want a combination of at least several styles for their diversification benefit—meaning that when one style is doing badly another style may be doing well.

Stock funds: Morningstar divides stock funds into nine style categories, ranging from large-cap value (considered less risky) to small-cap growth (considered more risky). It is difficult for the manager of a fund to maintain the fund’s style because small stocks get larger and mid-cap stocks can get smaller or larger. Value funds can become blend funds or even growth funds. Style risk may also cause a tax problem in taxable accounts, where exchanging a profitable fund because of its style change may result in a capital gains tax.

Bond funds: Morningstar also divides bond funds into nine style categories ranging from short-term high-quality bonds (least risky to long-term low-quality bonds (most risky). Bond funds have a similar style-drift problem. As a bond fund’s portfolio ages, long-term bonds become mid-term, mid-term bonds become short-term, and short-term bonds reach maturity. This is a prime reason for the high turnover in most bond funds.

The bottom line: Total market index funds include all investment styles within their three broad categories (U.S. stocks, U.S. bonds, and International stocks). For this reason, the total market index funds in The Three-Fund Portfolio do not have a style drift problem. For you and me, that’s one less variable to worry about.

Benefit 9: Low Tracking Error

“Tracking error” is the difference between a fund’s return and the return of its chosen index benchmark. A primary goal of index fund managers is to track their benchmark index as closely as possible. Vanguard recently reported that Total Stock Market has lagged its index an average of only 0.14% since its inception, Total International lagged by 0.29% and Total Bond Market by 0.29%. Compared to managed funds, these are very low tracking rates and were the result of good management, great diversification, low volatility, and low cost.

Tracking error may not be noticeable when it’s small. However, when tracking error is negative over long periods, or significant over short periods (both of which happen to actively-managed and sector funds), the fund’s investors may be tempted to change to a better-performing “hot” fund—one of the worst mistakes investors can make.

Benefit 10: Above-Average Return

Would you like to own a three-fund portfolio that is mathematically certain to outperform most amateur and professional investors? Well, you can. Each fund in The Bogleheads’ Guide to the Three-Fund Portfolio is guaranteed to do just that. Skeptical? You should be. (It’s a sign of a good investor).

There are many academic studies showing that index funds nearly always beat their managed funds counterparts. Here are a few:

S&P Dow Jones SPIVA Scorecard: In 2002, S&P Dow Jones Indices introduced its first SPIVA Scorecard, which is the most reliable data comparing managed funds with index funds. Below are quotes from the 2017 year-end SPIVA report:

“Over the 15-year period ending December 2017, 83.7% of large-cap, 95.4% of mid-cap, and 93.21% of small-cap managers trailed their respective (index) benchmarks.”

“Across all time horizons, the majority of managers across all international equity categories underperformed their benchmarks.”

“Funds disappear at a significant rate. Over the 15-year period, more than 58% of domestic equity funds were either merged or liquidated. Similarly, almost 52% of global/international equity funds and 49% of fixed-income funds were merged or liquidated. This finding highlights the importance of addressing survivorship bias in mutual fund analysis.” (Funds with poor results are the ones normally merged or liquidated.)

National Association of College and University Business Officers (NACUBO): Colleges can afford to buy the investment advice of the best and most expensive portfolio managers to handle their endowments, so it is interesting to see their results: According to a press release issued in January 2017, data collected for NACUBO show that “reporting institutions’ endowments returned an average of -1.9% (net of fees) for the 2016 fiscal year (July 1, 2015–June 30, 2016)” and “contributed to a decline in long-term 10-year average annual returns to 5.0%—well below the median 7.4% that most institutions report they need to earn in order to maintain their endowments’ purchasing power after spending, inflation, and investment management costs.” (Meanwhile, the Russell 3,000 Total Market Index returned 7.4%.)

Allan Roth study: Mr. Roth, is a CPA, CFP, and fee-only financial advisor. He writes the monthly Investing column for AARP magazine and is the author of How a Second Grader Beats Wall Street (using The Three-Fund Portfolio).

For this wonderful book, written in 2009, Allan did a study to determine the probability that an all-active fund portfolio will beat an all-index fund portfolio—when the index fund expense ratio was 0.23 and the managed fund ratio was 2.0. The table prepared by Allan shows that one managed fund had a 42% chance of beating an all-index fund over a 1-year period, but that the chances become less and less as more funds are added and as the length of time increases, until there is only a 1% chance with ten active funds after 25 years.

Rick Ferri study: Mr. Ferri, CFA, is a retired financial advisor and the author of six highly regarded financial books. As described in Chapter 3, Mr. Ferri did a study of 5,000 randomly selected portfolios of actively-managed mutual funds and compared them to the funds in The Three-Fund Portfolio. The study’s conclusion: “Dedicated active-fund investors can look forward to a 99% probability their portfolio will underperform an all-index fund portfolio over their lifetime.”

William Sharpe paper: William Sharpe, Nobel Laureate, wrote “The Arithmetic of Active Management” for the Financial Analysts Journal in 1991 and came to the following conclusion (italic mine): “Properly measured, the average actively-managed dollar must underperform the average passively-managed dollar, net of costs. Empirical analyses that appear to refute this principle are guilty of improper measurement.”

Paul Samuelson, Nobel Laureate: “Statistically, a broad-based stock index fund will outperform most actively-managed equity portfolios” (from “Challenge to Judgment,” the lead article in the 1974 inaugural edition of the Journal of Portfolio Management).

On January 12, 2018, Paul Farrell’s “Lazy Portfolios” column reported total returns for eight professionally-designed Lazy Portfolios for one, three, five, and ten-year periods. The Second Grader’s Starter Portfolio, consisting of The Three-Fund Portfolio of total market index funds, topped all the others—another real-world report showing that The Three-Fund Portfolio, as espoused in this book, works over multiple time periods.

The financial industry does not want us to know that index funds have higher returns than managed funds because they make their money promoting higher-cost managed funds. In an attempt to disparage index funds, one large broker-dealer, Sanford C. Bernstein & Co. LLC, described passive investing as promoting a system of capital allocation worse than Marxism. Nevertheless, the tide is turning. At the end of 2016, index funds (including ETFs) represented 24.9% of all equity funds, and the percentage is rapidly increasing as investors learn about indexing’s higher returns.

As an investor, you have a choice: You can be like the gamblers who try to beat the casino, or you can be the casino by investing in total market index funds. It’s an easy choice, once you understand the odds.

Benefit 11: Simplified Contributions and Withdrawals

One problem for investors holding multi-fund portfolios is that each contribution and each withdrawal must be spread among all the funds in the portfolio in order to maintain the desired portfolio asset allocation. Having only two stock funds and one bond fund makes this task considerably easier and more efficient.

Let’s take a look at how that works for an investor with a portfolio of a larger number of mutual funds. Many of these types of portfolios contain at least some active funds and often include some balanced funds. In this case, there could well be overlap among the funds, since the balanced funds contain some equities and some bonds. As a result, investors making contributions or withdrawals would need to closely examine the current breakdown in each of their funds to determine their current asset allocation, prior to making any contributions or withdrawals. Since there is no overlap between equities and bonds in The Three-Fund Portfolio, this makes contributions and withdrawals far simpler.

Benefit 12: The Benefit of Consistency

Investors appreciate a mutual fund or an ETF that is consistent, compared with a fund that is volatile, changes managers, changes style or takes unnecessary risk in the hope of market-beating performance.

Vanguard Total Stock Market Index Fund is known for its consistency when compared to other stock funds. As of this writing, Vanguard Total Stock Market Index Fund Admiral Shares (VTSAX) has beaten its Morningstar category average every year since its inception in 2001. Very few funds can claim this consistency. One of the greatest benefits of total market index funds is that you will never have to worry about your portfolio underperforming the market, because you own the market.

In 2007, the Vanguard Energy Fund Admiral Shares (VGELX) had a very good year. It gained 34.81% compared to the Vanguard Total Stock Market Index Fund, which gained 5.57%. Investors rushed into energy funds to enjoy anticipated profits, but the table following shows what happened during the next 10 years.

VTSAX vs VGELX, Comparative Annual Returns

Benefit 13: Low Turnover

“Turnover” is the ratio of how much of a fund’s securities are replaced each year. For example, if a mutual fund invests in 100 different stocks and 50 of them are replaced during one year, the turnover ratio would be 50%. All mutual funds and ETFs have turnover.

Following are recent turnover rates for each Vanguard fund in The Three-Fund Portfolio compared with the turnover rates of all funds in the same category:

Mr. Bogle suggests, as a rule of thumb, that turnover costs are equal to about one percent of a fund’s assets. Turnover costs (which are hidden from investors) include commissions, spreads, impact and administrative costs. Turnover costs do not include the additional tax cost to investors when the turnover results in capital gains distributions to the investor. Turnover costs often are larger than a fund’s published expense ratio (i.e., management fees and operating expenses combined).

Morningstar reported that for the 10 years ending in December 2016, the average U.S. diversified equity fund returned 5.15%. However, primarily because of higher turnover and bad market timing, fund investors averaged only a 4.30% annual return. That difference hurts all of us, so we should do everything we can to minimize it.

Total market index funds have among the lowest stock and bond turnover rates. The result is extremely low turnover costs for Three-Fund Portfolio investors, with the savings meaning higher returns for all of us.

Benefit 14: Low Costs

Most of us have learned from experience that cheap goods and services are usually not as good as more expensive goods and services. Paying more will often buy a better house, a better car, better clothing, better airline seats, and better service. It is, therefore, understandable that many investors believe that paying more for expensive funds, expensive financial advice, and expensive investments will result in better results.

The opposite is nearly always true. Investing in a simple three-fund portfolio of total market index funds eliminates the need to choose from among pricey funds, advisors and individual investments, thus putting more money in your pocket and less in theirs.

Fund costs are key to your ultimate returns.

In our Bogleheads’ Guide to Investing, we reported on a study done by Financial Research Corporation to determine which mutual fund predictors really worked:

• Morningstar STAR ratings
• Past performance
• Turnover
• Expenses
• Manager tenure
• Net sales
• Asset size
• Alpha (excess return)
• Beta (volatility)
• Standard deviation
• Sharpe Ratio

This was their conclusion: “The expense ratio is the only reliable predictor of future mutual fund performance.”

Morningstar (a primary source for reliable mutual fund data) did a similar study and came to the same conclusion: “If there’s anything in the whole world of mutual funds that you can take to the bank, it’s that expense ratios help you make a better decision. In every single time period and data point tested, low-cost funds beat high-cost funds.”

In 2014 Mr. Bogle did a study of total fund costs (before taxes) for the CFA Institute. Here are his findings:

All-in Investment Expenses for Retirement Plan Investors

Mr. Bogle understates the index fund advantage, because tax costs were not included. He once estimated that “taxes have in the past cost fund investors an extra 1.5% percent per year compared to holding the market portfolio.”

Total market index funds have costs, but they are much lower than managed-fund costs. One reason is that total market funds have extremely low turnover. Unlike most mutual funds and ETFs, total market index funds do not need to buy or sell stocks when a company moves from one category to another. Turnover often results in a capital gain in other funds, which is then passed on to the fund’s owners.

The three mutual funds in The Three-Fund Portfolio enjoy extremely low costs:

To give you an idea of the impact of costs, consider this: If stocks gain an average of 6% annually during the next 30 years, someone who invested $25,000 with a 1% yearly fee will forego more than $35,500 in gains because of the fee— more than the original investment!

Like Mr. Bogle, I believe that the hard-earned money saved and invested should be yours.

Benefit 15: Maximum Diversification (Lower Risk)

If there is one thing about investing on which all authorities agree, it is the benefit of diversification, often called “the only free lunch in investing.”

The primary benefit of diversification is that diversified mutual fund investors will never have all their investments in an underperforming fund, thus having a much greater chance of achieving their goals.

The Three-Fund Portfolio contains more than 15,000 world-wide securities for the ultimate diversification. Wall Street may try to sell you a more complex (and expensive) portfolio, but it is unlikely to be more diversified. The world, in a sense, becomes your oyster.

According to Morningstar, the level of risk contained in the stocks that are represented in the S&P 500 and the Wilshire 5000 total market index is about 25% less than the risk in the average active stock fund.

The Lehman Brothers bankruptcy in 2008 is an example of the need for diversification. Lehman Brothers was founded in 1850, and in 2000 it was the fourth largest investment bank in the United States. In the 2008 Bear Market, Lehman Brothers went bankrupt, causing thousands of their employees and individual investors who owned Lehman Brothers shares to lose all, or part, of their retirement benefits and life savings.

Vanguard Total Stock Market Index Fund investors also owned Lehman Brothers shares in their fund, but because their fund was diversified with thousands of other stocks, Total Stock Market fund shareholders were little affected by the bankruptcy. This is another advantage for total market index funds: Because all your stocks and bonds are wrapped into one fund, you don’t see the carnage that unnerves other investors, causing them to worry and sell at exactly the wrong time (i.e., during Bear Markets).

Diversification, with its lower risk, is the hallmark of The Three-Fund Portfolio. It protects us from allowing our brain—wired to sometimes flee out of fear—to become our own worst enemy.

Benefit 16: Portfolio Efficiency (Best Risk/Return Ratio)

Total market index funds are highly efficient, due to the fact that they offer the highest return for the amount of risk. This extremely important benefit is little known by the majority of investors and it gets little notice in the press.

“Portfolio efficiency” gets into higher mathematics, so I will let John Norstad, a retired mathematician at Northwestern University, explain:

“Many people do not understand why the cap-weighted total US stock market (TSM) plays such a central role in financial economics. They believe that TSM is just one of many possible US stock portfolios, with no good reason to believe that it is special or superior to other kinds of stock portfolios. They often present alternatives which they claim offer a higher expected return than TSM with less risk. In technical terms, these alternatives are ‘more efficient’ than TSM. We give three proofs that, under three different assumptions, TSM is efficient in the sense that no other U.S. stock portfolio can be more efficient than TSM (have lower risk and higher expected return).” (Italics mine.)

No one can predict the future, but it is reassuring for The Three-Fund Portfolio investors to know they hold a very “efficient” portfolio.

Benefit 17: Low Maintenance

All portfolios, like a good car that keeps on running, require regular maintenance:

• Funds need rebalancing.
• Contributions and withdrawals change.
• New fund offerings need consideration.
• Funds are merged and liquidated.
• Asset-allocation may need adjustment.
• Changes in income, expenses and net-worth may require adjustment.
• Changes in tax laws and the investor’s tax bracket may require adjustments.
• Beneficiaries change.

These and other maintenance items require knowledge, time and attention.

The need for portfolio maintenance, and the opportunity for mistakes, is magnified in direct proportion to the number of funds in a portfolio.

The Three-Fund Portfolio, with only three total market index funds, requires minimum maintenance. This means investors will have less worry and thus may spend more time with family and friends, doing whatever they enjoy. I promise you will learn to appreciate all the repairs or fixes that are not required with operating such a simple portfolio.

Benefit 18: Easy to Rebalance

“Rebalancing” takes place when it’s necessary for an investor to exchange fund shares in a portfolio to maintain the portfolio’s desired asset allocation.

Knowledgeable investors understand that, more than anything else, the stock/bond ratio in a portfolio determines our expected return and expected risk. For this reason, it’s very important to maintain one’s desired asset allocation between stocks and bonds. (We’ll talk more about asset allocation in Chapter 5).

The values of the securities in stock and bond funds change constantly. Small changes don’t matter, but over time the value of individual funds, especially stock funds, can change substantially. This requires rebalancing, which, in taxable accounts, can trigger capital gains taxes.

In another form of rebalancing, each of the funds in The Three-Fund Portfolio automatically adjusts its holdings to match its index benchmark on an almost-daily basis. Although it requires buying and selling securities by the fund managers, this internal rebalancing within each fund only rarely results in capital gains distributions to total market shareholders.

While it is necessary for investors to rebalance the three total market index fund portfolio to maintain the desired asset-allocation, this rebalancing is easier and more often results in a much smaller capital gains tax.

Benefit 19: Tax Efficiency

Smart investors want to keep their taxes as low as possible. Index funds, especially total market index funds, are among the most tax efficient of all funds when located in taxable accounts. (Tax efficiency isn’t a factor in tax-advantaged accounts such as IRAs, 401Ks, 403Bs, etc.)

The tax cost ratio measures how much a fund’s annualized return is reduced by the taxes investors have to pay on distributions. (For example, if a fund had a 2% tax cost ratio, it means that investors in that fund lost 2% of their assets to taxes.) According to Morningstar (January 12, 2018), the average tax cost ratio for equity funds tends to fall between 1 and 1.2%. As of this writing, Vanguard Total Stock Market Index Fund has a 15-year tax cost ratio of 0.40—less than half the tax cost ratio of the average equity fund.

The tax efficiency of total stock market index funds derives from several sources:

• Lower turnover by the passive fund manager, who doesn’t need to exchange stocks that trigger taxes that are later passed on to fund shareholders as distributions. Unlike most equity funds, Vanguard Total Stock Market Index Fund and Total International Stock Index Fund haven’t distributed a taxable capital gain since 2000.
• Lower turnover by the individual investor, because there is no need to buy and sell total market stock funds, triggering personal taxes. (Total Stock Market Index Fund already owns nearly every listed stock.) Likewise, there should be no need to sell Total Bond Market Index Fund shares, since it automatically maintains its broad diversification.
• Eligibility for lower tax rate. Vanguard Total Stock Market and Total International Index Funds are eligible for a reduced federal tax rate called “Qualified Dividend Income” (QDI). In 2017 Total U.S. Stock Market had 92% of its distributions qualify for the lower QDI rate while Total International Stock Fund and its ETF had 71% of its distributions eligible for the lower QDI rate. (Bonds are not eligible for the QDI rate, which is one reason taxable bond funds are usually best placed in tax-advantaged accounts.)

Investors should never forget that it’s the after-tax returns that count.

Benefit 20: Simplicity (for Investors, Caregivers, and Heirs)

Jack Bogle likes to say, “Simplicity is the master key to financial success.” His words ring loud and clear, in contrast to the financial industry that tries to convince us that investing is so complicated we must buy their expensive products and services if we want to be successful investors. Nothing could be further from the truth.

Bill Schultheis, advisor and author of The Coffeehouse Investor, also wrote about simplicity: “When you simplify your investment decisions, not only do you enrich your life by spending more time with families, friends and careers, you enhance portfolio returns in the process.”

According to The Investment Company Institute, in 2016 there were 8,066 mutual funds from which investors were able to choose. Fund marketing can be subtle, but most mutual fund companies try to convince investors that their funds will do (or have done) better than other companies’ funds. (Vanguard does not compare company returns.)

One of the most frequent requests on the Bogleheads’ online forum is for help with simplifying a portfolio. For example, we recently had a request to help a new Boglehead “track” his portfolio, which contained a mish-mash of 90 overlapping securities. The forum participant didn’t realize that “tracking” wasn’t his problem. His primary problem was his very confusing and complex high-cost portfolio—the result of using several advisors who were friends and relatives.

This confused investor didn’t realize that a simple three-fund portfolio contains more stocks and more bonds (and at a much lower cost) than his unwieldy portfolio of 90 individual securities.

A portfolio with fewer (and larger) funds has many advantages:

• Lower costs
• Fewer hidden turnover costs
• Better tax efficiency
• Avoidance of low-balance fees
• Less distortion from contributions and withdrawals
• Less rebalancing
• Lesser chance of errors
• Easier tax preparation
• Less paperwork, storage
• Less stress
• More free time with family and friends

Simple to understand and maintain, the Three-Fund Portfolio does not require higher mathematics, spreadsheets, complicated tax returns, being glued to the television before, during, and after market hours, or reading the Wall Street Journal.

My personal portfolio, all with Vanguard, requires very little maintenance. I use the Vanguard website a few times a year to check for fraud or mistakes. (It has never happened). I am over 70 ½ years old, so I use their website once a year to take the Required Minimum Distributions from my retirement plan. (Vanguard mails me a statement every year showing how much I must withdraw. Thank you, Vanguard.) My year-end Vanguard statement gives me the balance of each of my three funds and is all I need to rebalance to my desired asset allocation. I probably spend about an hour a year managing my stay-the-course portfolio. I leave it to you to imagine what you can do with all the time you will be saving investing in this way.

My simple portfolio is not just very easy for me to manage; it will be easy for my ultimate caregivers and my heirs to manage.

Many Bogleheads add a signature line at the bottom of their forum posts—something that expresses an idea we want to share. I chose this quote from Jack Bogle, as I find it one of his most important messages: “Simplicity is the master key to financial success.”