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Financial stocks – what they are and why you should invest in them

The financial sector is, for good reason, one of the darling sectors on Wall Street. Financial equities are known for steady, reliable growth that

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The financial sector is, for good reason, one of the darling sectors on Wall Street. Financial equities are known for steady, reliable growth that exceeds the inflation rate. At the same time, the sector is bringing in some of the best dividends on the market.

Perhaps this is why two of the biggest interests in the legendary value investor are Warren Buffett’s portfolio in the financial sector.

But what exactly are financial stocks, what are the pros and cons of investing in them, and how many 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 operating in the financial services industry. The sector includes:


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  • Retail and Commercial Banks and Lenders. Banks and lenders offer deposit accounts such as check and savings accounts and loans such as mortgages and car 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. Brokers, investment banks and other companies that provide services related to asset management 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 obtained at the point of purchase with a credit card. Some of the most popular players in this space include Citi (C) and American Express (AXP).
  • Fintech Companies. Fintech companies mix finance with technology to provide services that make managing your finances easier. Some of the most popular fintech players include Block (SQ) – formerly Square – and PayPal (PYPL).
  • Insurance companies. Insurance companies that provide health, life, car, home and other forms of insurance fall into the financial category. Metlife (MET) and Humana (HUM) are among the most popular insurance stocks.

Pros and cons of financial stocks

As with any other sector, there are pros and cons to investing in the financial sector. Although the sector is known for stable growth and dividends, it is not the best option if you are looking for market leading price increase. Some of the major advantages and disadvantages that you need to consider before investing in the space are outlined below.

Advantages

The financial sector offers a relatively low-risk way to access stable growth and dividends, but this is not the only benefit of investing in the sector. Some of the biggest benefits of financial stocks include:

  1. Lower risk. The financial sector has a lower risk than some other sectors such as technology and healthcare. This stability has improved significantly over the past few years. According to Davis Funds, the largest US banks are now keeping record volumes of cash on their balance sheets thanks to lessons learned during the 2008 financial crisis. Stock prices also tend to be more stable in the sector.
  2. Dividend Income. Financial stocks are known for providing strong dividend payments. By mid-2022, the sector was delivering an average dividend yield of 3.11%, according to Dividend.com.
  3. Strong Growth When Interest rates Stand up. Banks make more money when the Federal Reserve raises the Fed fund rate. As inflation rises, the Federal Reserve has hinted at steady rises for the foreseeable future, suggesting that bank shares are worth your attention.
  4. Exceed inflation. Historically, financial sector investment returns have significantly exceeded the inflation rate, making it a major inflation hedge.

Disadvantages

While there are many reasons to consider diving into financial stocks, there are also some major disadvantages that you need to consider before taking the plunge.

  1. Finances are not strong growers. Financial stocks are known for steady growth, not necessarily strong growth. If you are looking for growth stocks, you may find some in the fintech space, but growth investors will be better served by stocks in the technology sector.
  2. Lower earning potential When the Fed Fund rate is low. Although the Federal Reserve has indicated it will increase its rate going forward, the rate is currently below 1%. This low rate means companies in the sector, especially lenders, have limited revenue potential.
  3. Lack of excitement. The best investments are educated investments, which means you need to explore opportunities to be successful in the market. Unfortunately, the financial sector is not as sexy as technology and biotechnology for most people. The research process for evaluating financial companies can be daunting for some investors.

Do you need to invest in financial stocks?

Financial equities fit well into most investment portfolios. Even aggressive investors who seek to beat the market find it useful as a means of diversification. Nevertheless, there are some investors who will not find diversification with these assets beneficial.

You may be a good candidate to invest in financial stocks if:

  • You are an income investor. The financial sector is known for providing some of the strongest dividends on the market today. Thus, income investors benefit from the excessive dividend yields associated with investing in some of the most established companies in the industry.
  • You are risk averse. If you have a low to moderate appetite for risk, financial stocks can be a good home for your investment dollars. These stocks are known for relatively low volatility compared to stocks in other sectors, and most banks have sharpened their cash and cash equivalent holdings since 2008, giving them a strength to take into account at the financial stage.
  • You are an aggressive investor who needs balance. If you are an aggressive investor who wants to beat the market, chances are good that you will 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 are a beginner. If you are a novice investor, it is best to stay with large, secure companies that you know and do business with before embarking on other investments. Financial institutions often comply with this bill. In fact, one of the best first investments you can make is often an investment in the stock of the bank you are using. That is, as long as you work with a large financial institution.

How much of your portfolio should you allocate to financial stocks?

The amount of allocation you have to make to the financial sector is highly dependent on your goals and risk tolerance. Here’s how to decide how much to invest in financial stocks:

  • Your goals. Your goals play an important role in determining the best style of investment. If your goals include producing slow, yet meaningful and stable profits while generating income from your investments, the financial sector is a good place to start. Consider allocating a large portion of your equity portfolio to equities in the sector. However, if you want to make market-leading profits and you are not so worried about income, minimal allocation to finance is best.
  • Your risk tolerance. Financial stocks experience less volatility than stocks in other sectors and are known for holding a hefty sum of cash on their balance sheets. Consequently, these are relatively low-risk plays. If you have a low-to-moderate risk tolerance, a large allocation to finance adjusts the account. 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 are known for high dividend yields. Financial stocks are a great option if you are dependent on the income that your investments generate. So, if you are a retiree, a large allocation to this sector is justified.

Do not forget your safe harbor award. 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 do not know how to research and maintain a balanced portfolio of stocks or do not have the time to do so, you have another option. You can invest in financial exchange traded funds (ETFs).

These funds raise investment dollars from a group of investors to buy financial stocks and other securities. When the stock rises in value, investors share in the price increase. In addition, when the shares 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 cheap to enter. With a little research on the best performing funds in the financial sector, you can follow a largely hands-off approach to exposure to the financial sector.

The best financial ETF for you depends on your investment objectives. 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).


Final Word

Financial equities are a great addition to just about any investment portfolio. If you are an income investor or a risk-averse investor, you will enjoy the relatively stable price increase and significant dividends in the financial sector. If you are a more aggressive investor interested in growth, financial stocks are a great way to bring balance to your portfolio through diversification.

It’s no wonder that almost every investment magnate from Warren Buffett to George Soros has at least some degree of allocation to the sector.

Financial stocks tend to perform best when economic conditions are positive and interest rates are rising. From mid-2022, that seemed to be the case. Consumer prices are rising, and the Federal Reserve has hinted at forthcoming interest rate hikes that will bode well for financial corporations’ profitability. This indicates that financial equities will rise going forward.

However, not all stocks in the financial sector are created equal. Some grow while others fall. Some pay dividends while others do not. Simply put, some are winners and some are losers. Always do your research and get a good understanding of what you are investing in before you risk your hard earned money.

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