The financial sector is one of the darling sectors on Wall Street for good reasons. Financial stocks are known for steady, reliable growth that outpaces the rate of inflation. At the same time, the sector comes with some of the best dividends on the market.
Perhaps that’s why two of the largest holdings in the legendary value investor Warren Buffett’s portfolio are in the financial sector.
But what exactly are financial stocks, what are the pros and cons of investing in them, and how much of your investment dollars should you allocate to the sector? Read on to find out!
What Are Financial Stocks?
The financial sector is a broad category of companies that work in the financial services industry. The sector includes:
- Retail and Commercial Banks and Lenders. Banks and lenders offer deposit accounts like checking and savings accounts and loans like mortgages and auto loans. Two of the most popular companies in this subcategory include Bank of America (BAC) and Wells Fargo (WFC).
- Asset Managers and Investment Banking Services. Brokerages, investment banks, and other companies that provide services surrounding the management of assets fall into this subcategory. Some of the most popular players in this corner of the financial sector include JPMorgan (JPM) and Morgan Stanley (MS).
- Credit Card Companies. Credit card companies, also known as card issuers, offer revolving loans that can be accessed at the point of purchase using a credit card. Some of the most popular players in this space include Citi (C) and American Express (AXP).
- Fintech Companies. Fintech companies blend finances with technology to provide services that make managing your finances easier. Some of the most popular fintech players include Block (SQ) — previously Square — and PayPal (PYPL).
- Insurance Companies. Insurance companies that provide health, life, auto, home, and other forms of insurance fall into the financials category. Metlife (MET) and Humana (HUM) are some of the most popular insurance stocks.
Pros & Cons of Financial Stocks
As with any other sector, there are advantages and disadvantages to investing in the financial sector. Although the sector is known for stable growth and dividends, it’s not the best option if you’re looking for market-leading price appreciation. Some of the most important pros and cons to consider before investing in the space are detailed below.
The financial sector offers a relatively low-risk way to access stable growth and dividends, but that’s not the only perk of investing in the sector. Some of the biggest advantages of financial stocks include:
- Lower Risk. The financial sector comes with lower risk than some other sectors like technology and health care. This stability has improved significantly in recent years. According to Davis Funds, the largest U.S. banks are now holding record volumes of cash on their balance sheets thanks to lessons learned during the financial crisis of 2008. Stock prices tend to be more stable in the sector as well.
- Dividend Income. Financial stocks are known for providing strong dividend payments. As of mid-2022, the sector produced a 3.11% average dividend yield, according to Dividend.com.
- Strong Growth When Interest Rates Rise. Banks make more money when the Federal Reserve increases the Fed funds rate. As inflation rises, the Federal Reserve has hinted at steady increases throughout the foreseeable future, which suggests bank stocks are worth your attention.
- Outpace Inflation. Historically, financial sector investment returns have significantly outpaced the rate of inflation, making them a great inflation hedge.
Although there are plenty of reasons to consider diving into financial stocks, there are also a few big drawbacks that you should consider before taking the plunge.
- Financials Aren’t Strong Growers. Financial stocks are known for steady growth, not necessarily strong growth. If you’re looking for growth stocks, you may find a few in the fintech space, but growth investors will be better served by stocks in the tech sector.
- Lower Earning Potential When the Fed Funds Rate Is Low. Although the Federal Reserve has hinted at increasing its rate ahead, the rate is currently below 1%. This low rate means companies in the sector, particularly lenders, have limited revenue potential.
- Lack of Excitement. The best investments are educated investments, meaning you need to research opportunities to be successful in the market. Unfortunately, the financial sector isn’t sexy like technology and biotechnology is for most people. The research process to evaluate financial companies may be daunting for some investors.
Should You Invest in Financial Stocks?
Financial stocks fit well into most investment portfolios. Even aggressive investors who seek to beat the market find them useful as a means of diversification. Nonetheless, there are some investors who won’t find diversification with these assets beneficial.
You might be a great candidate to invest in financial stocks if:
- You’re an Income Investor. The financial sector is known for providing some of the strongest dividends on the market today. So, income investors benefit from the outsize dividend yields that come with investments in some of the most established companies in the industry.
- You’re Risk-Averse. If you have a low to moderate appetite for risk, financial stocks may be a great home for your investment dollars. These stocks are known for relatively low volatility when compared to stocks in other sectors, and most banks have beefed up their cash and cash equivalent holdings since 2008, making them a force to be reckoned with on the financial stage.
- You’re an Aggressive Investor Who Needs Balance. If you’re an aggressive investor who wants to beat the market, chances are you’ll want to invest most of your assets in other sectors. However, you can use financial stocks as a way to diversify your holdings and reduce the overall risk in your portfolio.
- You’re a Beginner. If you’re a beginner investor, it’s best to stick with large, safe companies that you know and do business with before venturing into other investments. Financial institutions often fit this bill. In fact, one of the best first investments you can make is often an investment in the stock of the bank you use. That is, as long as you work with a major financial institution.
How Much of Your Portfolio Should You Allocate to Financial Stocks?
The amount of allocation you should direct to the financial sector is heavily dependent on your goals and risk tolerance. Here’s how you should decide how much to invest in financial stocks:
- Your Goals. Your goals play an important role in determining the best style of investing. If your goals include producing slow, yet meaningful and stable gains while generating income from your investments, the financial sector is a great place to start. Consider allocating a large portion of your stock portfolio to stocks in the sector. However, if you want to produce market-leading gains and you’re not so concerned about income, minimal allocation to financials is best.
- Your Risk Tolerance. Financial stocks experience less volatility than stocks in other sectors and are known for maintaining a hefty sum of cash on their balance sheets. As a result, they’re relatively low-risk plays. If you have a low-to-moderate risk tolerance, a large allocation to financials fits the bill. However, if you have a moderate-to-high risk tolerance, you may want to keep allocation to the sector to a minimum.
- Your Need for Investment Income. Financial stocks are a great option for retirees because they’re known for high dividend yields. Financial stocks are a great option if you depend on the income your investments generate. So, if you’re a retiree, a heavy allocation to this sector is warranted.
Don’t forget your safe-haven allocation. Fixed-income investments, gold, and other safe havens protect you from significant losses when stocks take a dive. So, always keep safe havens in mind when determining your portfolio’s asset allocation.
Consider Financial ETFs
If you don’t know how to research and maintain a balanced portfolio of stocks or don’t have the time to do it, you have another option. You can invest in financial exchange-traded funds (ETFs).
These funds collect investment dollars from a group of investors to purchase financial stocks and other securities. When the stocks rise in value, investors share in the price appreciation. Moreover, when the stocks held in the fund’s portfolio pay dividends, shareholders receive their share of dividends based on the number of ETF shares they own.
The best part is that financial ETFs are managed by professionals yet very inexpensive to tap into. With a little research on the best performing funds in the financial sector, you can take a largely hands-off approach to financial sector exposure.
The best financial ETF for you depends on your investment goals. Popular financial ETFs on the market today include the Financial Select SPDR Fund (XLF), the Vanguard Financials ETF (VFH), and the SPDR S&P Regional Banking ETF (KRE).
Financial stocks are a great addition to just about any investment portfolio. If you’re an income investor or a risk-averse investor, you’ll enjoy the relatively stable price appreciation and meaningful dividends in the financial sector. If you’re a more aggressive investor who’s interested in growth, financial stocks are a great way to bring balance to your portfolio through diversification.
It’s no wonder that nearly every investing mogul from Warren Buffett to George Soros seems to have at least some allocation to the sector.
Financial stocks tend to do best when economic conditions are positive and interest rates are on the rise. As of mid-2022, that seemed to be the case. Consumer prices are rising, and the Federal Reserve has hinted at coming interest rate hikes that will bode well for financial corporation profitability. This suggests financial stocks will head up moving forward.
However, not all stocks in the financial sector are created equal. Some grow while others fall. Some pay dividends while others don’t. Simply put, some are winners and some are losers. Always do your research and get a good understanding of what you’re investing in before risking your hard-earned money.