Heritage Investment Review September 30, 2019


A good financial advisor focuses on appropriate timeframes when discussing investment results which are best measured over periods of ten years or longer—and we will focus on long-term themes in this investment review. However, we will begin with a brief update on year-to-date asset class returns.

Source: Morningstar, Inc.

Investing in stocks and bonds this year, despite the ever more commonly heard R-word (recession) has been rewarding. The majority of financial markets’ returns were reaped in the first quarter. The second quarter continued the positive march, but at a slower pace. The third quarter produced mixed results,    without much overall impact in a well-diversified portfolio.
A prudently diversified portfolio has produced a total return in the upper single digits over the first three quarters of 2019. These results beat cash in the bank and certainly helped families move a step closer to their financial goals.
As much as an upper-single-digit return over 9 months is an excellent outcome, the returns displayed above lead to the reasonable question: “Why don’t I own more U.S. stocks and have a return closer to 15% or even 20%?”
First, we will look back over the prior two decades to formulate an appropriate answer to this question. Next, we will discuss pursuing strategies within stock markets that aim to produce higher returns. Last, we will touch on structuring a portfolio with built-in resilience for a variety of conceivable scenarios.


The Yin Yang Decades

January 2000 – December 2009

Waking up the morning after celebrating Y2K, an investor in the U.S. stock market could scarcely have guessed what the next ten years had in store for him (and yes, his computer worked).

Many financial plans had an annual return assumption of 10% for U.S. stocks, which equates to a ten-year expected compounded cumulative return of 160%. And why not? The ten-year U.S. treasury rate was 6.58%. Most financial modelers assume an equity market premium of 4% to 5% above risk-free government bonds.
What actually transpired stunned investors in U.S. stocks.


Source: Morningstar, Inc.

This was a bad start to the new millennium to say the least. An investor in U.S. stocks lost 2% of his money over the decade while the general price level of goods and services he had to buy went up by 28%.
Diversification would have been his saving grace. Notably, emerging markets stocks produced a compounded cumulative return of 149% (close to that 10% annualized return) while bonds produced an 85% compounded cumulative return, significantly outpacing inflation.
Should an investor in December 2009 have concluded that U.S. stocks were not worth investing in anymore?

January 2010 – September 2019

Going to bed on New Year’s Eve 2009, it’s doubtful a retiree from 10 years earlier who invested only in U.S. stocks was partying like it was 1999. Maybe she was considering the dreadful task of crafting a résumé for the first time in many years and tossing it into the vast pool of others from the 9.9% unemployed. Surely her financial plan didn’t play out the way it had looked on paper.
A dejected investor in only U.S. stocks from 2000 to 2009 might have lost faith in financial markets and slogged towards the dim light of inflation-beating, FDIC-insured CDs; an engaged investor in only U.S. stocks over the same period might have reviewed the past decade’s returns and decided to sell U.S. stocks and buy international stocks to catch the tide; a globally-diversified stock and bond investor would have experienced gains ahead of inflation. She might have rebalanced at the end of 2009, banked gains from emerging markets stocks, sold appreciated bonds with coupons well above market rates, and bought primarily U.S. stocks.

The second decade of the millennium would tell a different tale altogether than the first.

Source: Morningstar, Inc.

No matter the asset class, investing produced positive nominal and real (net of inflation) returns. Clearly, however, the U.S. stock market was the decade’s champion.


Investing Lessons from this Millennium

Reviewing the two decades since ushering in the new millennium, a few lessons stand out.

Source: Morningstar, Inc.

1. Investing works for growing wealth in excess of inflation
2. Over any decade, a major global stock market can be down
3. Diversification enabled an investor to arrive at a similar return with materially less risk and psychological strain
4. A globally-diversified stock and bond investor made money and beat inflation during both decades

The two decades represent black-and-white extremes. Living in financial extremes is unhealthy. What we recommend is to walk the middle path with diversification—moving forward as consistently as possible without the disruptive highs and lows.


Pursuing Excess Returns within Stock Markets

Value investing vs. growth investing

Within the U.S. stock market and international stock markets, we believe value stocks will outperform growth stocks. The historical fact is clear—value stocks have outperformed growth stocks over the long run. But, after a bout of underperformance, the debate has grown louder on whether value investing is dead.


Source: Dimensional Fund Advisors

Over the past decade value stocks have performed in line with expectations (102% of their historical average). Meanwhile, growth stocks have performed abnormally well (168% of their historical average).
In financial markets, when one sees an abnormality compared to a long history of empirical evidence, it typically reverts to the mean rather than setting a new normal. Past examples include the dominance of growth stocks leading up to the Tech Bubble bursting in 2000, and home prices leading up to the Great Financial Crisis in 2008.

Dimensional Fund Advisors

Value stocks producing a premium return to growth stocks is an academic concept easy to wrap your head around. In practice, there’s a lot that goes into implementing a strategy successfully. There are thousands of value managers, the majority of whom underperform the market. Heritage utilizes Dimensional Fund Advisors (DFA) as our primary stock manager.
DFA is a research-driven, institutional investment manager who has developed and refined its stock investing strategies over the past 37 years. They’ve been able to identify persistent market premiums—value over growth, small cap over large cap, high profitability over low profitability—that are economically intuitive, statistically significant, and implementable in practice.
Through the knowledge they’ve gained and the systems they’ve engineered over the years, DFA has built a reliable suite of funds available to us at a low cost. In the U.S., despite a decade over which growth has performed unusually well, DFA has still been able to keep up with the market.
In months when value outperformed growth and small cap outperformed large cap, DFA significantly outperformed the market. It’s exciting to consider what the next decade may bring should value stocks and small cap stocks outperform as they have in the past. The same principles apply internationally.

Source: Dimensional Fund Advisors


Building a Resilient Portfolio

A healthy exercise for an asset allocator is to consider a series of what if scenarios and test how portfolios are likely to perform under each of them. Then the allocator may tweak various exposures to trade off some upside in one scenario for better downside protection in another scenario. Having an allocation that’s resilient under a wide array of scenarios increases an investor’s probability of experiencing good long-term results.
One scenario we considered includes higher-than-expected inflation. There are a few concrete reasons this is a viable possibility.
1. Over the past decade, inflation has annualized well under its long-term average and the Federal Reserve (Fed) wants symmetry in inflation’s variation from their target
2. Commodity prices are at a multi-year cyclical low
3. Unemployment is 3.5%—below the estimated natural rate
4. The Fed is cutting interest rates
5. Political pressure on the Fed for spurring growth is high

An immediate reaction is to consider asset classes that would likely do well in an inflationary environment: short-term T-Bills, gold, and TIPS. The issue with these assets is their effect on portfolio returns under base-case, status quo scenarios.
A middle ground is real assets that produce income: commercial real estate, infrastructure, farmland, and timberland. These asset classes have a clear path to 5% or 6% return in the status quo scenarios. If there is inflation, the value of nominal financial assets generally decrease, but real assets fare much better (rents typically go up with inflation, or the price of corn going up on farmland is part of the cause of inflation).
Having analyzed these scenarios, we’ve undertaken an extensive search for the best managers and products through which to access commercial real estate, infrastructure, farmland, and timberland. As a result, we expect to reduce bond exposure—where we’ve earned strong returns this year—to add these asset classes over the upcoming quarter for many of our clients.



Asset class returns thus far in 2019 are strong. A well-diversified investor has a positive real return year-to-date.
We don’t aim to hit the extremes—our portfolios don’t produce returns that reach the best performing asset class in any year; they also don’t produce returns that resemble the worst performing asset class in any year. Over time, the total return is competitive, but our investors don’t experience the real and emotional travails of an undiversified, highly-volatile portfolio.
Within the stock market, we believe that value investing continues to be the right long-term strategy to pursue. Value stocks have produced returns right in line with their long-term average over the past decade. Growth stocks appear to be abnormally expensive. DFA is a seasoned manager who we’re confident in to deliver the excess returns we expect from global value stocks and small cap stocks in the years ahead.
In reviewing the current economic environment, we believe portfolios can be made more resilient by building out a real assets allocation. We want to focus on real assets that produce income, ideally covering commercial real estate, infrastructure, farmland, and timberland.
We appreciate your business and trust in our process. Our aim is to provide as good of an experience as possible in strategizing for and achieving your financial goals. Returns in 2019 to date represent a step in the right direction on a long-term journey.



This newsletter has been prepared solely for informational purposes, and is not an offer to buy or sell, or a solicitation of an offer to buy or sell, any security, product, service or investment. The opinions expressed herein are solely the opinions of Heritage Financial Services and do not constitute investment advice and are subject to change without notice. Heritage customizes client portfolios based on individuals’ financial situations. Various components of this commentary may not be relevant to each client’s personal portfolio due to, without limitation, portfolio legacy securities, portfolio size, accounts with limited investment options, tax considerations, investment accreditation and personal preferences. Past performance may not be indicative of future results.
All data contained herein are believed to be accurate as of the date of publication. Data sources include Morningstar, Inc., Yahoo! Finance, Charles Schwab, and various cited publications. Certain third-party sources are relied upon for historical statements and performance information. Heritage is under no obligation to update this document as additional information becomes available or if any revisions are made to information herein contained.