This article may resemble a plump turkey writing about how to prepare a perfect Thanksgiving dinner (and I appreciate limiting further comparisons of the writer to a turkey).

I am writing to review a book I recently finished – The Bogleheads’ Guide to the Three-Fund Portfolio.

The author is part of an internet discussion group called The Bogleheads which was inspired by John (Jack) Bogle, former head of fund group Vanguard.  Bogle was a pioneer in the development of index funds and is an outspoken critic of much of the mutual fund industry.

In this concise 112 page book, it is explained that investing is fairly simple – just buy three low cost index funds:

• Total Stock Market Index
• Total International Stock Index
• Total Bond Market

Also, spend well below your means and maintain a good savings rate.

The three funds included in the portfolio represent the entire U.S. stock market, stock market outside of the U.S., and U.S. investment grade bond market.  This combination of funds results in an extremely low cost portfolio with very broad diversification.  The author favors Vanguard funds but notes that in today’s competitive world versions from Charles Schwab, Fidelity and others are just as good.

I would quibble with parts of the book and will below but the premise is quite solid and I have no doubt the book’s recommendations will lead to results that outperform the majority of investors. A major reason for this conclusion is simply cost – the low cost of the funds gives them a big head start against actively managed mutual funds that most won’t be able to overcome.

My main personal differences with the book include:

• International stocks – As much as I respect and agree with John Bogle in most areas, he believes that investors don’t need to include international stocks and if they do, they should be limited to 20% of the stock portion of the portfolio (i.e., if stocks are 60% of the total portfolio, there should be 48% in U.S. stocks and 12% in international stocks).  Bogle does note that after a long period of U.S. outperformance that it might be time for mean reversion to favor international stocks.  I would agree more with Vanguard’s recommendation that at least 20% of the stock allocation be targeted to international stocks.  We typically recommend 40% (and even higher during periods of more favorable valuations such as exist currently).
• Three funds – While this approach definitely checks the box for KISS (keep it simple, stupid!), I think if using an all index approach that it is better to use more funds to allow for tax loss harvesting and better rebalancing.  For example, using S&P 500 and  small/mid cap index funds for  U.S. stocks and developed and emerging markets funds on the international side.
• Inclusion Of Index Funds That Are Not Cap Weighted  – A full discussion of this area would take several pages but I believe that having 100% of a portfolio in cap weighted index funds (such as the S&P 500) isn’t the best approach.  The best example of why is the S&P 500 in 1999 which resembled a technology sector fund after the huge gains of .com internet stocks. The S&P 500’s collapse of approximately 50% in the years following was significantly worse than funds that were not weighted as heavily in technology stocks.  There are approaches to indexing that are not actively managed but look beyond cap weighting to company fundamentals.  I believe including some allocation to fundamentally weighted index funds makes sense.

The author does skewer the financial industry (mostly deserved) but also acknowledges that a qualified financial advisor can be valuable to some investors.  For starters, the book doesn’t provide (and can’t) the right combination of the three funds for an investor although it does provide tips.  Determining the right target asset allocation, staying the course when the inevitable bear market hits, rebalancing, etc.  are areas where an advisor can add value on the investment side.  At least as important, a good advisor can assist with the myriad of financial planning needs outside of simple investment portfolio construction.  That said, an advisor (especially one working on commissions) that offers only investment advice using high cost vehicles is likely facing a difficult future.

Douglas M. Lynch, CPA, CFA, CFP