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What is the 'Financial Sector'

The financial sector is a category of the economy made up of firms that provide financial services to commercial and retail customers. This sector includes banks, investment funds, insurance companies and real estate. Financial services perform best in low-interest-rate environments. A large portion of this sector generates revenue from mortgages and loans, which gain value as interest rates drop.

BREAKING DOWN 'Financial Sector'

The financial sector is one of the most important parts of many of the world's developed economy. It is one of the largest portions of the S&P 500. The largest companies within the financial sector are some of the most recognizable banking institutions in the world such as JPMorgan Chase & Co., Wells Fargo & Company, Bank of America Corporation and Citigroup Inc. Along with banks, the financial sector also consists of insurance, REITs, capital markets, consumer finance, financial services and mortgage finance. The second largest industry within the sector is insurance companies, which includes firms such as American International Group and Chubb Limited.

When the business cycle is on an upswing, the financial sector benefits from additional investments. Improved economic conditions usually lead to more capital projects and increased personal investing. New projects require financing, which usually leads to a larger number of loans.

Why Invest in the Financial Sector?

Financial stocks are very popular investments to own within a portfolio. Most companies within the sector issue dividends and are judged on the overall strength of their financial health. In the financial crisis of 2007-2008, the financial sector was one of the hardest hit with companies such as Lehman Brothers filing for bankruptcy. After an influx of government regulation and restructuring, the financial sector is considerably stronger in 2016. Economists often tie the overall health of the economy with the health of the financial sector. If financial companies are weak, this is a detriment to the average consumer. Financial companies provide loans for businesses, mortgages to homeowners and insurance to consumers. If these activities are restricted, it stunts growth in both small business and real estate.

Over the last 10 years, the sector has produced a negative 1 percent overall return for investors for the period ending May 31, 2016. This was caused by the financial crisis that produced catastrophic returns in 2007, down 18.63 percent, and 2008, down 55.32 percent. However, over the last five years, the sector has rebounded, giving investors an annual average return of 10.55 percent. This slightly under performs the total S&P 500, which has a total return of 11.06 percent for the same period. Investors looking for a sector bouncing back from a crisis and successful in a low-interest rate environment should consider the financial sector.

Factors Affecting the Financial Sector

Some of the positive factors that affect the financial sector include:

  • Rising interest rates on a moderate basis: As rates rise, it means that these companies can earn more on the money they have and on credit they issue to their customers. 
  • Reducing regulation: Whenever the government decides to cut back on the red tape, members of the financial sector will benefit, because that means it could lessen the burden while increasing profits. 
  • Helping consumers with finances: As consumers decrease their debt loads, they lessen the risk of defaults. This lighter load also means that they may have a tolerance for more debt, further increasing profitability. 

Conversely, investors should consider some of the negative factors that affect this sector as well:

  • Rapidly rising interest rates: If rates should rise too quickly, demand for credit such as mortgages could drop, which could negatively affect certain parts of the financial sector. 
  • A flattening yield curve: If the spread between long- and short-term interest rates drop too far, the financial sector could start to struggle. 
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