Common wisdom dictates that diversification and costs matter when it comes to portfolio design.
To that end, we often take great care in picking dozens of funds or hundreds of individual securities to build a diversified portfolio. After all, we want to include all stock industries, sizes and styles, as well as both corporate and government bonds.
Yet all of this can be achieved with only three simple funds. Our clients can own virtually every U.S. stock with a total stock index fund such as the Schwab US Broad Market Fund (SCHB). We can build an international stock portfolio of developed and emerging market countries that includes all sizes of stocks with the Vanguard Total International ETF (VXUS). To own an approximation of every investment grade taxable fixed-rate bond the client there is the iShares Aggregate Bond Fund ETF (AGG).
In fact, one might argue that a single global stock fund can replace the U.S. and international funds. The problem is that they generally don’t own small cap stocks, and thus are a bit less diversified.
Now clients may say they can’t be diversified with only three funds, but they couldn’t be more diversified, at least when it comes to stocks. Adding any other stock fund will actually make the portfolio less diversified since they’ll end up with more of one size, style, or sector than the market overall.
When it comes to bonds, you may feel that more diversification is appropriate and decide to add fixed income classes not in the bond fund. That could include Treasury Inflation Protected Securities (TIPS), high-yield (junk) bonds, municipal bonds, and international bonds.
The ultimate conclusion from Modern Portfolio Theory (MPT) is to own every security from every major asset class, thus eliminating selection risk. Something that can be accomplished by building simple and transparent portfolios with annual expense ratios averaging 0.10% or less.