Investing doesn’t have to be complicated. I’ve spent nearly twenty years studying the financial markets. I majored in finance and worked as a trader at a major Wall Street investment bank. After all these years following the market, I’ve concluded that the best portfolio for the average investor isn’t some complicated trading strategy or a mix of high-cost actively managed mutual funds. No, it is actually a diversified mix of low-cost index funds. I especially like the three-fund portfolio.
Vanguard is the largest index fund manager in the world. While there are other excellent index fund managers (e.g. Fidelity, Schwab) that offer funds with low expense ratios (ER), Vanguard remains the gold-standard in index fund management. In this article, I will help you build a portfolio of index funds with Vanguard. We’ll start with a simple portfolio (just one-fund!). Then we’ll slowly add funds based on how complex (which is not necessarily better) you want your portfolio to be.
One-Fund Portfolio: U.S. Stocks
Legendary investor Warren Buffett has repeatedly written that the average investor should invest their money in a S&P 500 fund. The S&P 500 is composed of the 500 largest publicly-traded U.S. companies. The Vanguard 500 Index Admiral Shares (VFIAX, ER = 0.04%) is the fund that Warren Buffett prefers. By investing in the S&P 500, you’ll get the market return that most investors try (and typically fail) to beat.
However, since the S&P 500 index only contains large-cap stocks, I prefer the Vanguard Total Stock Market Index Admiral Shares (VTSAX, ER = 0.04%), because it gives you ownership of small-cap and mid-cap stocks in addition to large-cap stocks. By investing in more than 3,500 stocks, the Vanguard Total Stock Market Index fund provides a more diversified portfolio than the S&P 500 portfolio.
Two-Fund Portfolio: Add U.S. Bonds
For many investors, especially young investors, the one-fund portfolio is all you need. But since U.S. stocks are very volatile, most investors will want to add some bonds to their portfolio. Bonds are much less volatile than stocks, and they often move in opposite directions as stocks (including during the 2008 financial crisis). The Vanguard Total Bond Market Index Admiral Shares (VBTLX, ER = 0.05%) is a great way to purchase the U.S. bond market. By investing in over 8,500 corporate and U.S. government bonds, this index fund gives you a broad, diversified portfolio of U.S. bonds.
Three-Fund Portfolio: Add International Stocks
With just two funds, you have now invested in the entire U.S. economy. This is a great portfolio for many investors. But since the U.S. economy is only a fraction of the global economy, you can increase diversification by adding an international stock market index fund. The Vanguard Total International Stock Index Admiral Shares (VTIAX, ER = 0.11%) gives you broad exposure to both developed international stock markets (such as Europe and Japan) as well as emerging markets (such as Latin America, Russia, and China).
Adding a third fund to your portfolio is completely optional; Vanguard founder Jack Bogle doesn’t invest in international stocks.
Four-Fund Portfolio: Add International Bonds
The three-fund portfolio is a very popular portfolio. I don’t purchase any additional asset classes beyond U.S. stocks, international stocks, and U.S. bonds. However, some investors may be interested in more complicated portfolios.
The next fund I would add to your portfolio is international bonds. International bonds will not move in lock-step with the U.S. bond market, so you can increase the diversification of your portfolio by adding a fourth index fund. The Vanguard Total International Bond Index Admiral Shares (VTABX, ER = 0.12%) is an excellent low-cost way to get exposure to the international bond market. It contains over 4,200 international bonds, including bonds from foreign governments and international corporations. The index contains bonds from both developed and emerging markets.
Five-Fund Portfolio: Add REITs
With a four-fund portfolio, you now have exposure to the entire global stock and bond market. If purchased in the correct proportions, you can replicate Vanguard’s Target Retirement Funds. Creating your portfolio this way will be cheaper than purchasing the Target Retirement Fund directly from Vanguard.
However, there are alternative asset classes that don’t move with either the stock or bond markets. Because of their low correlation to stocks or bonds, adding these alternative asset classes can further increase the diversification of your portfolio.
The most popular alternative asset class is real estate. Many investors who do not invest directly in real estate will nevertheless have exposure to real estate prices through the ownership of their primary home. You can invest in real estate by purchasing individual investment properties, but this would be like investing in just a single stock. To get broad exposure to the real-estate market with an index fund, you can purchase the Vanguard REIT Index Admiral Shares (VGSLX, ER = 0.12%).
Here are the five portfolios, in order of complexity. Remember that Admiral Shares have a $10,000 minimum investment, so if you want to invest less than that in a particular index fund, purchase the equivalent exchange-traded fund (ETF) instead, which has no minimum investment.
|One-Fund: Start with U.S. Stocks (S&P 500)||VFIAX||VOO|
|One-Fund: Start with U.S. Stocks (Total Stock Market)||VTSAX||VTI|
|Two-Fund: Add U.S. Bonds||VBTLX||BND|
|Three-Fund: Add International Stocks||VTIAX||VXUS|
|Four-Fund: Add International Bonds||VTABX||BNDX|
|Five-Fund: Add REITs||VGSLX||VNQ|
That’s how you create a diversified index fund portfolio using Vanguard mutual funds. As Steve Jobs would say, “It’s that easy.” You can start with the Vanguard 500 or Vanguard Total Stock Market Index and gradually add funds as you read and learn more about investing. You don’t need to have a degree in finance or Wall Street trading experience to do this. With any of the portfolios I described above, you’ll likely beat the majority of the fund managers on Wall Street.
What do you think? Do you use Vanguard index funds in your portfolio?