This guide is still under construction.

Welcome to my investment series, where I share how to invest in index funds in less time. See the index for the other articles.

In this article, we compare and contrast three good options for passive investing: roboadvisors, target date funds, and three fund portfolios.

By the end, aim to complete the following sentence stems:

  • I choose to use a  ____________ (roboadvisor / target date fund / three fund portfolio) because ______________________________.
  • If I choose a target date fund, I will choose a fund with the retirement year ______.
  • If I choose a three fund portfolio, I will allocate _____ % of my portfolio towards U.S. stocks, ______ % towards international stocks, and ______ % towards U.S. bonds. And I will rebalance once a year.

These sentence stems are part of the worksheet that accompanies this investment series. You can make a copy of the Google doc, which can be found here.

Note, if you aren’t familiar with any of the following terms, click to learn their definitions: 

Index Fund, Mutual Fund, ETF, Diversification, Asset Class, Asset Allocation

Let’s get started :)

Table of Contents

Table of Contents

My Recommendation

Use target date funds if you're new to investing. These funds are a great mix of convenience and cost savings.

Use three fund portfolios if you're looking to optimize, or if you have a significant portfolio (say $100k+). These save you even more on fees.

Read on to understand in full.

What are my options?

In an investment strategy for retirement, we look for low-fees strategies with good diversification and good returns. And all three of these options fit the bill—so don’t get too stuck deciding!

Three fund portfolios

A three fund portfolio is an investment portfolio which consists of just three index funds. You hold an index fund representing each of these three buckets, or asset classes:

  • US Stocks
  • US Bonds
  • International Stocks
  • Meme stocks (jk)

There are rules of thumb to decide what percentage of the portfolio should be in each category (your asset allocation), and I’ll share those later.

Note the following though. Since the index funds will change in value over time, once a year you should buy or sell shares to return to your desired asset allocation. This is called rebalancing.

Target date funds

Target date funds are index funds that change their asset allocation based on how close you are to retirement.

A target date fund with a retirement date forty years out, will have a more aggressive allocation than one with a retirement date ten years out.

And under the hood, they’re basically three fund portfolios (Vanguard’s are technically four fund portfolios) where the provider rebalances for you.

Thus, with target date funds, you only have to hold the one target date fund until retirement!

Also known as lifecycle funds or target retirement funds.

Roboadvisors

Roboadvisors are websites that provide automated investing with little human supervision. They pursue similar asset allocations to three fund portfolios—a tad more complex, but same intent.

The original innovators in the space were Betterment and Wealthfront, and they have easy account setup. Complete a survey, figure out your risk tolerance, and move on.

There’s one feature they have worth noting: tax loss harvesting, which helps you evade taxes save on taxes. 

More on this later, but tax loss harvesting only applies to taxable accounts—in tax-advantaged accounts like 401(k)’s and IRAs, investments grow tax-free, so it doesn’t apply.

What are their fees?

For an index fund, the annual fee is expressed as a percentage of your investment—what’s known as an expense ratio (ER). If you have $100k in an index fund with an expense ratio of 0.15%, that’s $150 a year in fees.

Roboadvisors have management fees, which are the same thing. If you have $100k in an index fund with their management fees of 0.25%, that’s $250 a year in fees.

Here are the fees, by option:

Three fund portfolios: Combined ER of 0.05%

Target date funds: ER of 0.15%

Roboadvisors: Management fees of 0.25%

I assume Vanguard index funds. I assume Wealthfront or Betterment for the roboadvisor (they have the same fees). For simplicity, I didn’t account for the ERs of the index funds that roboadvisors trade on your behalf.

Here’s a comparison of the fees over a thirty year timeframe.

Three fund portfolio vs. target date fund



Target date fund vs. roboadvisor



Use this Nerdwallet calculator to mess with the numbers yourself.

Note the more money you have in your account, the more you pay in fees. Yeah, that’s how percentages work 😛

I bring this up because the following thought process is reasonable:

“Oh, I’ll pick a more convenient strategy for now, since it doesn’t cost much.  Then, when I have more money in my account (and convenient strategies cost more), I’ll buy more GME and also I’ll switch to a three fund portfolio.”

OK, let’s zoom back out for a second.

What are their pros and cons?

Three fund portfolios

Three fund portfolios are the least convenient, but have the lowest fees, and that matters.

Pros

  • Get the lowest fees
    Three fund portfolio: ER of 0.05%
    Target date fund: ER of 0.15%

    With a $100,000 investment that you hold for thirty years, the three fund portfolio would save you $20,000 in fees.
  • Place funds based on their tax efficiency
    Some funds (e.g. stocks) are tax-efficient while some funds (e.g. bonds) are tax-inefficient.

    With this portfolio, you can put your tax-inefficient funds in a tax-advantaged account and your tax-efficient funds in a taxable account.
  • Customize your asset allocation
    If you want to, you can customize your asset allocation any which way you want.

Cons

  • Have to figure out your asset allocation

    You have to learn and decide what percentage to allocate for each asset class.

  • Have to rebalance once a year

    It only takes a couple hours, but it can still be a bother to rebalance. It’s about as fun as doing your taxes.
  • Have to harvest tax losses by hand (if you want to)

    It can be tedious to harvest tax losses by hand. But you can do it, and you only have to do it once a year.

Target date funds

Target date funds and roboadvisors are more convenient. Of the two, target date funds have the lower fees. Also, they might be the only option available in your 401(k).

Pros:

  • Let you buy just one fund

    Buy this one fund and mostly forget it until retirement.
  • Let you set it and forget it

    You don’t need to rebalance.
  • Are likely available through your 401(k)

    Target date funds are most likely available in your 401(k).
  • Less costly than roboadvisors

    Target date fund: ER of 0.15%
    Roboadvisor: Management fees of 0.25%

    With a $100,000 investment that you hold for thirty years, the target date fund would save you $20,000 in fees.

Cons:

  • Aren’t customizable

    Some people who want more control over what exactly index funds their portfolio holds.

    That said, you can always pick a different target date fund than the one for your age. This allows you to be more conservative or more aggressive than your age, if you want.
  • More costly than three fund portfolios

    Target date fund: ER of 0.15%
    Three fund portfolio: ER of 0.05%

    With a $100,000 investment that you hold for thirty years, the target date fund would cost $20,000 more in fees.
  • Can’t harvest tax losses

Roboadvisors

Roboadvisors are the most hands off option, but also have the highest fees. But they do offer automated tax loss harvesting...

Pros:

  • Make setup so simple

    Sign up, fill out welcome survey, set up automatic deposits and forget about it.
  • Let you set it and forget it

    You don’t need to rebalance.
  • Get the benefits of tax loss harvesting without the work

    Wealthfront says this saves 3x your management fees! That said, it only applies to taxable accounts, and there are some complications you’ll want to understand that I talk about later.
  • Get other nice features

    See In Detail: Roboadvisors for some of Wealthfront’s fancy features. I would say these are less proven and not too relevant for the decision, but decide for yourself.

Cons: 

  • More costly than the other two options

    Roboadvisor: ER of 0.15%
    Target date fund: ER of 0.05%
    Three fund portfolio: ER of 0.05%

    With a $100,000 investment that you hold for thirty years, the roboadvisor would cost $20,000-$40,000 more in fees.

You can use these options in combination.

Say, a target date fund in your 401(k) because it’s available, a three fund portfolio in your IRA for cost savings, and a Wealthfront for a taxable account for the tax loss harvesting.

(There would be complications with the TLH though, see here.)

Also, it’s more important to get started than to get it perfect. 7% annual returns squashes differences in fees like .1% or .2%.

Q&A: Three fund portfolios

What % stocks, what % bonds?

I recommend matching the asset allocations of the Vanguard target date funds.

Vanguard’s asset allocation for their target date funds are a function of how much time you have until your target date.

See this colorful chart from them:

X-Axis: Years to target date.

Y-Axis: Asset allocation.


Let’s say we’re >25 years out from retirement date. We can see stocks make up 90% of the allocation—the red and the yellow. We can see bonds make up 10% of the allocation—the blues, the bonds.

Thus, we conclude 90-10 is the split for us. That wasn’t so bad!

What % U.S. stocks, what % intl. stocks?

Vanguard allocates 60% to U.S. stocks and 40% to international stocks. It’s from that same chart.

There are more nuanced ways to derive your asset allocation, but it’s unlikely you’ll beat Vanguard, imo.

How often should I rebalance?

From the personal finance company Sofi:

“A good rule of thumb is to rebalance when an asset allocation changes more than 5%—ie. if a certain subset of stocks changes from 15% of your portfolio to 20%.”
“One study from Vanguard found there was no meaningful difference in risk-adjusted returns if the portfolio was rebalanced monthly, quarterly or annually—especially if you take into account the costs of doing it yourself with transaction fees.”

Put an annual reminder in your calendar to rebalance.

And write down your investment plan using this worksheet, because it takes a lot longer to rebalance if you have to rederive the “balance” your past self was planning.

Q&A: Target date funds

What year target date fund should I pick?

Assume you’ll retire at 65 and pick the corresponding target date fund.

Assume 65 and you can adjust as you get closer to retirement, in case you retire earlier or later. This applies especially if you’re under 40, because while you’re >25 years out from retirement, Vanguard target date funds at least use the exact same asset allocation.

Other notes:

  • The target date funds that are farther out have a higher risk/reward, so you could let your risk tolerance play into it a bit.
  • Target date funds come in multiples of 5, like 2020, 2025, … 2095, etc.

Q&A: Roboadvisors

What is tax loss harvesting?

It turns out that when an investment loses value, and you sell the investment and replace it with a similar one, you realize a “capital loss”. That “capital loss” can offset “capital gains” you’ve made—resulting in less taxes.

Roboadvisors do this for you automatically, but you can also do it by hand.

What are the complications around tax loss harvesting?

OK, here’s the deal: when you sell a stock to harvest its loss, you can’t just buy it back immediately. If you do buy it back within thirty days, the IRS considers this a “wash sale” and disallows the loss. 

And this is the complication with roboadvisors. Say Betterment tax loss harvests an S&P 500 index fund. But an automated purchase goes out from your 401(k) or your IRA to buy a similar fund. Then that triggers a wash sale on your behalf and nullifies any benefit.

Thus, to get the tax loss harvesting benefit of a roboadvisor, you have to pull of your money in the roboadvisor. 

You could try to be sure your non-roboadvisor investments don’t hold any of the same index funds, but that’s not so easy.

Fun fact: You can’t sell a fund and have your spouse buy it back for TLH—that’s also a wash sale. Perhaps a reason to avoid the legal institution of marriage :haha:

What are Wealthfront’s advanced features? And should I care about them?

We’ve already talked about their portfolio level tax loss harvesting, but Wealthfront advertises three other features.

Personally, I don’t think any of them are large factors in deciding which index fund option to choose.

One feature activates when you have >$100k in your account, and the other two activate when you have >$500k in your account.

When you have $100k in your account, Wealthfront can try to hold the stocks and bonds that represent an index fund, instead of the index fund itself. This saves on taxes, and is known as direct indexing or stock level tax loss harvesting.

When you have $500k in your account, Wealthfront allocates 20% of your portfolio to hold its risk parity fund. This is a mutual fund they manage that attempts to reduce the volatility of your investment, while maintaining the returns of investing in stocks.

People have gripes with this fund, as it’s 

  1. an actively managed fund
  2. with an expense ratio of 0.5%
  3. that is based on solid theory, but who knows in practice

You can opt out of the feature. See the debate on Reddit about the risk parity fund here.

When you have $500k in your account, Wealthfront also activates one last feature. This feature takes direct indexing a step further.

Index funds like the S&P 500 decide how much to hold of each stock based on each stock’s market cap. With this feature on, Wealthfront tries to weight each stock based not just on market cap, but a few other factors. They’re calling this Smart Beta.

Again, based on smart-sounding theory, but who knows in practice: check with your local finance bro to be sure.

You can opt out of Smart Beta. See the debate on Reddit about Smart Beta here.

Decisions, decisions

Here are those sentence stems to fill out again:

  • I choose to use a  ____________ (roboadvisor / target date fund / three fund portfolio) because ______________________________.
  • If I choose a target date fund, I will choose a fund with the retirement year ______.
  • If I choose a three fund portfolio, I will allocate _____ % of my portfolio towards U.S. stocks, ______ % towards international stocks, and ______ % towards U.S. bonds. And I will rebalance once a year.

Make your decision, and write it down. Then proceed to the next step: What Retirement Accounts To Use.