The three-fund portfolio is where I’d recommend stopping – at least until you have 5x-10x your annual spending saved up. A 3-fund portfolio is a solid asset allocation that you could live with for the rest of your life.
Most recommendations after that focus on splitting up any of the 3 funds into their specific parts and “tilting” them towards the more aggressive parts that make up that fund.
Let’s look at the international side to start. $VTIAX invests about 22% in emerging markets. Historically, emerging markets have outperformed international markets, so by splitting your investments between $VTIAX and a fund like $VEMAX, Vanguards Emerging Markets Fund, you increase your risk and also your potential for reward.
Here’s what “tilting” your portfolio to emerging markets would look like:
| Fund | Amount |
| $VTSAX – Vanguard Total US Market or$VFIAX – Vanguard S&P 500 | 48% |
| $VTIAX – Vanguard Total International Fund | 22% |
| $VEMAX – Vanguard Emerging Markets Fund | 10% |
| $VBTLX – Vanguard Total Bond Index | 20% |
You’re still investing 32% in international funds, but now it’s skewed heavily towards emerging markets.
If you want to stay in proportion with the world economy, you wouldn’t do this. For that, all you’d need is a 3-fund portfolio.
When I started investing, I tilted my portfolio with emerging markets. Eventually, I realized it wasn’t worth the added effort and eased off towards a 3-fund portfolio.
You can do the same to tilt your US investments in one way or another. Remember this chart?
With just these funds your portfolio is skewed towards large-cap funds. One of the most common “tilts” is to add a 2nd small-cap fund like $VSMAX, Vanguard Small-Cap Index Fund. This is similar to adding an emerging market fund – you would lower your investment in the general US fund and add in some small-cap.
The other 2 most common tilts are to add an additional Value index or growth index. Value tilts your portfolio towards more safe investments, while growth tilts it towards more risk and reward.
I might be sounding like a broken record, but you don’t need to do this. A 3-fund portfolio will invest in emerging markets and small-cap funds (if you’re investing with $VTSAX). Adding more increases your potential risk and reward, but not by much. We’re talking about a long-term average of less than a 1% difference for more work.
| Fund | Amount |
| $VTSAX – Vanguard Total US Market or$VFIAX – Vanguard S&P 500 | 38% |
| $VSMAX – Vanguard Small Cap Index | 10% |
| $VTIAX – Vanguard Total International Fund | 22% |
| $VEMAX – Vanguard Emerging Markets Fund | 10% |
| $VBTLX – Vanguard Total Bond Index | 20% |
Other Portfolio Tilts
You can break up your investments to tilt in other ways too – commodities and sectors. Investing in $VTSAX will already invest in all of these though! Take a look at the makeup of $VTSAX.
It already invests in technology companies to a huge extent. Same for financial services and health care.
One area that isn’t as well-represented is real estate. The real estate portion of $VTSAX is relatively small for how huge real estate is in the total economy of the united states.
What we can do is add an additional tilt there with $VGSLX, Vanguard Real Estate Index Fund. Here’s how Vanguard describes this fund.
This fund invests in real estate investment trusts—companies that purchase office buildings, hotels, and other real estate property. REITs have often performed differently than stocks and bonds, so this fund may offer some diversification to a portfolio already made up of stocks and bonds.
Vanguard description of $VGSLX
The fact that REITs historically perform differently from stocks and bonds and awesome! It means that adding a tilt towards that increases our diversification a bit. A portfolio with a REIT might look something like this:
| Fund | Amount |
| $VTSAX – Vanguard Total US Market or $VFIAX – Vanguard S&P 500 | 35% |
| $VSMAX – Vanguard Small Cap Index | 10% |
| $VGSLX Vanguard Real Estate Index Fund | 5% |
| $VTIAX – Vanguard Total International Fund | 20% |
| $VEMAX – Vanguard Emerging Markets Fund | 10% |
| $VBTLX – Vanguard Total Bond Index | 20% |
Special note here: REIT funds are the most tax-inefficient of ANY fund we’ve talked about so far. REIT funds give off dividends that are effectively rent passing through to you as a shareholder. These are nonqualified dividends and would be taxed at your ordinary tax rate. It’s very important that if you invest in REIT funds you put that investment in a tax-advantaged account like an IRA, 401k or Roth IRA.
When it comes to real estate investing, you may not need to add a REIT fund. If you own real estate outside of your stock investments then guess what: you’re already investing in real estate! I personally don’t own any real estate, so adding a few percentage points into a REIT fund allows me to benefit from a growing housing market without the need to keep a building standing.
I’m not going to go in-depth about tilting your bond index, but you can do the same thing there. The most common tilts are towards international bonds ($VTABX) and treasury inflation-protected securities ($VIPSX). In the same way, the US equity market is about half of the total equity market, the US bond market is about half of the world bond market. You could again split your bonds 60/40 between US and international to gain broader diversification.
Over the last 5 years, international bonds have gone up when US bonds go up, but slightly more.
Bonds are bought more for their yield than their growth. In this same period, the US fund had a higher yield, bringing their total performance in line with each other.
Ok, let’s review a few key points.
#1, to increase your risk-return, a common strategy is to “tilt” your portfolio by investing a small amount in an underweighted portion of that investment. Adding in a small amount of small-cap or emerging markets can increase your risk without the need to pick individual stocks.
#2, if you only want to add one more fund to your portfolio beyond the big 3, add a REIT fund! These prosper when the housing market thrives and can behave differently than equity markets and bond markets. Adding a REIT fund in a tax-advantaged account helps increase your diversification!
#3, one of the most common portfolio additions is an international bond fund. Bonds outside the US are a larger market than the US bond market, the US equity market or the international equity market. Adding this fund isn’t even a tilt since it’s not currently represented in our portfolio.
It’s easy to take diversification too far. You can keep splitting funds into their parts and then investing in those until you have thousands of investments. Doing that is a recipe for complexity. With a complex portfolio, you’re less likely to be able to rebalance, you’ll pay more in taxes, and you’ll have less flexibility.
One reason that many people add tilts to their portfolio is that they want to feel like they have more control over their investments.
I’ve said this before, but I’ll say it again: you don’t have control over what your investments do! No matter how many different investments you have, you won’t have control over how they do. The best you can do is create an asset allocation that matches your risk tolerance and then just let it be!
The difference between success and failure is not which stock you buy or which piece of real estate you buy, it’s asset allocation.
Tony Robbins
Asset allocation is a long-term plan for how you invest. It doesn’t need to be perfect either! It’ll change over time as your investments grow at different paces. Setting up an asset allocation that enables you to sleep at night is what matters.