Financial Services: Investing Essentials

The financial services sector is growing rapidly and comprising an ever-larger share of U.S. gross domestic product.

Aug 19, 2014 at 3:16PM

G

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.

G

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.

G

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.

G

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.

 

John Maxfield has no position in any stocks mentioned. The Motley Fool recommends Bank of America and Wells Fargo. The Motley Fool owns shares of Bank of America and Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

1 Key Step to Get Rich

Our mission at The Motley Fool is to help the world invest better. Whether that’s helping people overcome their fear of stocks all the way to offering clear and successful guidance on complicated-sounding options trades, we can help.

Feb 1, 2016 at 4:54PM

To be perfectly clear, this is not a get-rich action that my Foolish colleagues and I came up with. But we wouldn't argue with the approach.

A 2015 Business Insider article titled, "11 websites to bookmark if you want to get rich" rated The Motley Fool as the #1 place online to get smarter about investing.

"The Motley Fool aims to build a strong investment community, which it does by providing a variety of resources: the website, books, a newspaper column, a radio [show], and [newsletters]," wrote (the clearly insightful and talented) money reporter Kathleen Elkins. "This site has something for every type of investor, from basic lessons for beginners to investing commentary on mutual funds, stock sectors, and value for the more advanced."

Our mission at The Motley Fool is to help the world invest better, so it's nice to receive that kind of recognition. It lets us know we're doing our job.

Whether that's helping the entirely uninitiated overcome their fear of stocks all the way to offering clear and successful guidance on complicated-sounding options trades, we want to provide our readers with a boost to the next step on their journey to financial independence.

Articles and beyond

As Business Insider wrote, there are a number of resources available from the Fool for investors of all levels and styles.

In addition to the dozens of free articles we publish every day on our website, I want to highlight two must-see spots in your tour of fool.com.

For the beginning investor

Investing can seem like a Big Deal to those who have yet to buy their first stock. Many investment professionals try to infuse the conversation with jargon in order to deter individual investors from tackling it on their own (and to justify their often sky-high fees).

But the individual investor can beat the market. The real secret to investing is that it doesn't take tons of money, endless hours, or super-secret formulas that only experts possess.

That's why we created a best-selling guide that walks investors-to-be through everything they need to know to get started. And because we're so dedicated to our mission, we've made that available for free.

If you're just starting out (or want to help out someone who is), go to www.fool.com/beginners, drop in your email address, and you'll be able to instantly access the quick-read guide ... for free.

For the listener

Whether it's on the stationary exercise bike or during my daily commute, I spend a lot of time going nowhere. But I've found a way to make that time benefit me.

The Motley Fool offers five podcasts that I refer to as "binge-worthy financial information."

Motley Fool Money features a team of our analysts discussing the week's top business and investing stories, interviews, and an inside look at the stocks on our radar. It's also featured on several dozen radio stations across the country.

The hosts of Motley Fool Answers challenge the conventional wisdom on life's biggest financial issues to reveal what you really need to know to make smart money moves.

David Gardner, co-founder of The Motley Fool, is among the most respected and trusted sources on investing. And he's the host of Rule Breaker Investing, in which he shares his insights into today's most innovative and disruptive companies ... and how to profit from them.

Market Foolery is our daily look at stocks in the news, as well as the top business and investing stories.

And Industry Focus offers a deeper dive into a specific industry and the stories making headlines. Healthcare, technology, energy, consumer goods, and other industries take turns in the spotlight.

They're all informative, entertaining, and eminently listenable ... and I don't say that simply because the hosts all sit within a Nerf-gun shot of my desk. Rule Breaker Investing and Answers contain timeless advice, so you might want to go back to the beginning with those. The other three take their cues from the market, so you'll want to listen to the most recent first. All are available at www.fool.com/podcasts.

But wait, there's more

The book and the podcasts – both free ... both awesome – also come with an ongoing benefit. If you download the book, or if you enter your email address in the magical box at the podcasts page, you'll get ongoing market coverage sent straight to your inbox.

Investor Insights is valuable and enjoyable coverage of everything from macroeconomic events to investing strategies to our analyst's travels around the world to find the next big thing. Also free.

Get the book. Listen to a podcast. Sign up for Investor Insights. I'm not saying that any of those things will make you rich ... but Business Insider seems to think so.


Compare Brokers