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Financial Services: Investing Essentials

Over the last few decades, the financial services sector has been the focus of considerable attention and derision. On one hand, it has underwritten the extraordinary growth of the American economy since the end of World War II. But on the other, it has sometimes done so in an irresponsible and haphazard manner that lead to, among other things, the financial crisis of 2008-2009.

Regardless of how one views the financial services sector, there's no doubt that it's an important part of the U.S. economy. There's also no doubt that it offers discerning investors the opportunity to generate impressive returns.

What are financial services?

The financial services sector provides a variety of money-related services to businesses and consumers. For consumers, these include resources such as mortgages, checking and savings accounts, insurance products, and brokerage services. For businesses, it expands from traditional banking and insurance into investment banking and consulting.

Eight commonly recognized industries make up the financial services sector. Measured by market capitalization, the bank industry is the largest by a wide margin, followed by insurance, capital markets, and real estate investment trusts. Bringing up the rear are four considerably smaller industries: diversified financial services, consumer finance, real estate other, and thrift and mortgage finance.

The biggest and best-known players in the space are household names. Bank of America boasts nearly 50 million consumer and small business relationships. Wells Fargo claims to do business with one in three U.S. households. And JPMorgan Chase was founded by arguably the most recognizable financier in the history of the United States.

How big is the financial services sector?

It's difficult to overstate the size and significance of the nation's financial services sector. Measured by market capitalization, it is far and away the largest sector of the U.S. economy. Combined, the publicly traded companies that comprise it are worth more than $7.1 trillion. That's almost $2 trillion more than the runner-up, the technology sector.

Moreover, the financial services sector is growing rapidly. Since the end of World War II, its profits have grown by nearly 23,000%. By contrast, nonfinancial companies have seen an increase in earnings of only 4,500%. Thanks to this growth rate, the financial services sector now accounts for roughly 30% of total corporate profits in America -- a threefold increase over the last six and a half decades.

How do financial services work?

Two general types of business models prevail at companies that provide financial services. The first model relies on arbitrage to generate revenue and thereby earnings.

Technically speaking, arbitrage is the process through which pricing discrepancies between comparable assets are exploited. For instance, if corn is selling for $4.50 a bushel in Kansas City but $5 in St. Louis, then one could theoretically turn a profit simply by buying corn in the former and selling it in the latter.

And so it is at banks, insurance companies, real estate investment trusts, and other members of the financial sector. For instance, banks arbitrage interest rates. They borrow funds at low short-term rates, largely from depositors, and then lend the very same funds out at higher long-term rates. Real estate investment trusts do the same thing, though their funding source derives from the capital markets and not deposits.

The second type of business model is oriented toward the more traditional concept of services (though, for the record, many financial companies use both types). This model charges fees for services provided. If you've ever paid closing costs on a mortgage or car loan, then you're likely familiar with this business. And the same is true of services from brokerages and asset managers.

What drives financial services?

The financial sector has two principal profit drivers. The first is interest rates. Because a large share of the sector makes money by arbitraging short- and long-term rates, the precise relationship between the two makes a big difference. The bigger the so-called spread between the two, the better. On top of this, because interest rates are inversely correlated with the value of fixed-income investments, the direction of the former has a considerable effect on portfolio values across the sector.

The second driver is the velocity of financial transactions -- which, it's worth pointing out, is fueled by consumer confidence and the health of the underlying economy. If a brokerage company makes money by charging customers per stock trade, then the more trades the merrier. The same idea holds true for mortgage companies that charge fees to originate home loans.

The takeaway on financial services

For beginning investors, the financial services sector can seem like a "riddle wrapped in a mystery inside an enigma." And for good reason, as it's difficult if not impossible to grasp the potential risks and rewards that face the sector's most complicated participants.

At the same time, there's little doubt that this corner of the U.S. economy is bound to grow in both absolute size and in its share of gross domestic product. Whether you choose to participate in this is up to you. However, if you do, it's critical to do your homework before taking the plunge.


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  • Report this Comment On August 20, 2014, at 9:51 AM, TradeWithPat wrote:

    Interesting article written by John Maxfield.

    I am surprised one of the most common and profitable business lines for the financial service industry was left out. This is gathering assets from customers and charging fees for piling that money into mutual funds that track index benchmarks.

    Studies recently completed by Tastytrade show that a basic strategy of selling OTM puts in the SPY at the start of each month and selling OTM calls if assigned would demolish a passive income strategy.

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John Maxfield

John is The Motley Fool's senior banking specialist. If you're interested in banking and/or finance, you should follow him on Twitter.

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