Investing in the financial services sector poses a greater risk of loss compared to the broader market. However, financial stocks also deliver stronger-than-average returns when the market is up. Analysts measure the risks and returns of specific sectors compared to the broader market using a metric called the beta coefficient. A sector that moves in lockstep with the broader market and replicates its gains and losses is designated by a beta coefficient of 1. When a sector is more volatile than the broader market, meaning it experiences greater gains during a bull market and greater losses during a bear market, its beta coefficient is greater than 1. More stable sectors not subjected to the ups and downs of the market have beta coefficients of less than 1.
Financial services, a large sector comprising businesses such as stock brokerages, credit services companies and asset management firms, has a beta coefficient of 1.5 as of 2014. During a bull market, the average stock in the financial services sector gains $1.50 for every $1 gained by stocks in the broader market. The same is true for losses during a bear market, hence the reason this sector is considered riskier than average. Its high beta coefficient makes the financial services sector attractive to aggressive, growth-oriented investors with a high tolerance for risk.
Several key attributes make the financial services sector more volatile and thus riskier than the broader market. The most important one is that the very nature of its business depends on economic prosperity to be successful. Companies that profit by offering financial services such as mortgages and investment vehicles do well in good economic times when people have money to invest and buy homes; conversely, these companies tend to lose money during periods of economic turmoil when their customers default on their mortgages and are forced to cash out their portfolios to pay bills and living expenses.
Regulation is another factor that affects the financial services sector more than others. Especially after the financial crisis of 2007-2008, governments across the world began placing strict regulatory constraints on financial firms in an effort to prevent another catastrophe. Because this industry is in the regulatory authorities' crosshairs perhaps more than any other sector, and because new regulations have a tendency to lower stock prices, this translates to increased risk for investors in the financial service sector.
Given the sector's above-average risk, many investors choose to hedge their exposure to financial services by diversifying their portfolios with more stable investments such as utilities and blue chips. This gives them the best of both worlds. The financial sector securities outperform the market during good times, while the utility and blue-chip securities beat the market during not-so-good times.