What to consider when investing in the financial sector

The financial sector includes banks, insurance companies, asset managers and stock exchanges. It provides financial services both to individuals (retail customers) and to businesses (commercial customers).

The financial sector is quite diverse, and it is made up of many different businesses both large and small. However, all firms in the financial sector have some of the same benefits and risks for investors. In this guide, we will show you what to consider when investing in financials.

Financials go up – and down – with the economy

Analysts often refer to stocks as either cyclical or defensive. As the name suggests, defensive stocks can be a good defense during economic downturns. These companies make things that people have a hard time doing without, like consumer staples, and they usually pay a dividend, which can offset paper losses when share prices decline.

Cyclical stocks, on the other hand, go up and down with the economy. The financial sector is considered a cyclical sector.

Think about it this way: When the economy is strong, banks make more loans, more companies need to use banks’ capital for mergers and acquisitions, and more people – both individuals and institutions – trade financial instruments like stocks. But when the economy is weak, people lose their jobs, companies can’t pay back their loans and banks become less likely to lend money. All those things are bad for the financial sector’s bottom line, and shares of financial companies tend to suffer more during recessions.

In addition, financial stocks tend to have a high “beta,” meaning they are more volatile than the stock market as a whole. If a bumpy stock market that swings between profit and loss makes you uncomfortable, high-beta stocks will compound that feeling of unease.

Typically, when interest rates go up, so do bank profits

Rising interest rates are both good and bad for the financial sector. On the upside, when interest rates are higher, banks can charge more for loans and credit products (like credit cards). However, banks also pass higher earnings on to savers in the form of interest on certificates of deposit (CDs) and savings accounts. Recently, the cost of higher funding (i.e., the amount paid on those savings accounts) increased at a much faster pace for banks as the Fed quickly raised interest rates in 2022–23. As a result, if a bank didn’t raise the amount it paid enough to entice investors to stay, those funds flowed out to either other banks or to money market funds that had higher rates. This is what happened with the banks that failed in 2023 – deposit outflows resulted in a “run on the bank,” which ultimately caused them to fail.

When is a good time to invest in the financial sector?

Abigail Yoder, J.P. Morgan U.S. Equity Strategist, says that typically you want to own financials when a recession is ending.

“You’ll really want to consider owning financials in early- to mid-cycle coming out of a recession,” Yoder explained. This is when financial stocks typically have the most opportunity for growth. If growth falters, financials may suffer, but once the economy finds its footing, financials could well outperform.

In addition to catching the wave of an economic recovery, investors like financial sector stocks because they have a track record of yield during periods of growth. According to Yoder, “Shareholders gravitate toward healthy dividends and share buybacks, so from a yield perspective, we believe financials are attractive, particularly as the current administration pursues a deregulatory agenda, freeing up excess capital.”

How to invest in the financial sector

There are many quality investments in the financial sector, but as we mentioned above, there are also some downsides to investing in financials – especially when you’re not sure how the economy is going. How can you pick ones that align with your goals?

One way to potentially get the benefit of the financial sector while reducing your risk is to invest in sector-wide exchange-traded funds (ETFs) or mutual funds. These funds invest in a broad collection of financial stocks like banks, insurance companies and asset managers.

Investors who feel confident in a particular subsection of the financial sector can find these pooled investment products that focus specifically on subsectors like regional banks, large-cap banks and many other types of firms in the finance sector. Before making any investment decisions, be sure to consult a financial advisor or, if you invest on your own, do your own research.

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