Investing in Financial Stocks

When most people hear the term "financial sector," they think of banks. Although this is certainly the largest part of the financial sector, several other types of companies are included in the sector, as well.

Best financial stocks for beginners

Best financial stocks for beginners

These are some mature, easy-to-understand financial sector businesses that are smart choices for beginner investors:

• Berkshire Hathaway (BRK.A -1.32%) (BRK.B -1.32%) is not always thought of as a financial sector stock. However, it is an insurance company at heart, so it is technically a part of the sector. Led by legendary investor Warren Buffett, Berkshire is the parent company of GEICO as well as an enormous reinsurance operation. Investors in the company gain exposure to its massive stock portfolio, which also happens to own large stakes in financial heavyweights Bank of America (BAC -3.64%) and American Express (AXP -1.42%).
• JPMorgan Chase (JPM -3.6%) is the largest U.S. bank by assets, and has an excellent track record throughout a variety of economic environments. It's tough to make a case against JPMorgan Chase as an investment. The bank consistently posts some of the highest profitability metrics in the industry and has vast operations in both consumer and investment banking.
• Visa (V -0.87%) operates the world's largest payment network. Along with Mastercard (MA -0.14%), Visa has half of a near-duopoly over the payment processing industry. But don't make the mistake of thinking Visa doesn't have room to grow. The company currently processes about $14 trillion in annualized payment volume per year via more than 4 billion branded debit and credit cards.

As for financial sector exchange-traded funds (ETFs), the Vanguard Financials ETF (VFH -1.9%) may be an excellent choice. The fund gives investors exposure to the entire financial sector for a low 0.1% expense ratio (annual investment fee). The fund provides exposure to hundreds of financial sector stocks, weighted according to their market capitalizations, so more of the fund's assets are invested in the larger financial companies.

In addition to the three companies already mentioned, top holdings include Bank of America (BAC -3.64%), Citigroup (C -2.8%), BlackRock (BLK -1.48%), and Morgan Stanley (MS -2.32%).

Types of financial stocks

Types of financial stocks

Several different types of companies make up the financial sector. Companies in the financial sector vary widely by function, size, growth potential, and other factors.

Financial stocks can be broken into several categories, including:

• Banks: As previously mentioned, bank stocks make up the bulk of the financial sector. These include commercial banks, such as Wells Fargo (WFC -2.25%), which provide deposit accounts and loans to individuals and businesses. It also includes investment banks, such as Goldman Sachs (GS -2.38%), which provide services to institutions and high-net-worth investors. Some banks, like JPMorgan Chase, serve both commercial and institutional clients.
• Insurance: The second-largest part of the financial sector is the insurance subsector, which includes property and casualty insurers, life and health insurers, specialty insurers, and insurance brokers. Berkshire Hathaway is the largest company in the insurance subsector. This also includes so-called "insurtech" companies, such as Lemonade (LMND -4.08%).
• Financial services: Some companies provide services related to investing and the public markets without being classified as banks or insurers. The ratings agency S&P Global (SPGI -1.66%) and the futures exchange CME Group (NYSE:CME) are two examples of financial service providers.
• Mortgage REITs: Companies that own mortgages and other financial real estate instruments, known as mortgage real estate investment trusts (mREITs), are another group in the financial sector.
• Fintech: Financial technology, or fintech companies, are those that leverage technology to create new solutions for the financial industry. Visa, PayPal Holdings (PYPL -2.63%), and Block (SQ -3.98%) (formerly known as Square) fit into this category.
• SPACs: A special purpose acquisition company, or SPAC, is a company with no business operations that exists to take another company public. Also known as "blank check" companies, SPACs are considered part of the financial sector.

Analyzing financial sector investments

Analyzing financial sector investments

Investors can evaluate financial industry investments by using both standard metrics, such as the price-to-earnings (P/E) ratio, and custom, sector-specific metrics. For the banking and insurance subsectors of the financial industry, there are some particularly important metrics for investors to consider.

These metrics are especially useful for analyzing bank stocks:

• Return on equity (ROE) and return on assets (ROA): Two of the most widely used metrics to express bank profitability, ROE and ROA are a company's annualized profits expressed as percentages of shareholders’ equity and total assets, respectively. A 10% ROE and a 1% ROA are often considered to be the industry benchmarks.
• Net interest margin (NIM): Most banks earn the majority of their profits by simply loaning money and charging interest to customers. The difference between the average interest rate a bank receives and the average rate it pays plus certain expenses is known as its net interest margin.
• Efficiency ratio: A bank's efficiency ratio measures how much money the bank spends to generate revenue. For example, a 60% efficiency ratio means that a bank spends $60 to generate every $100 in revenue. Lower efficiency ratios are better.
• Net charge-off (NCO) ratio: Calculating this ratio can be useful for comparing asset quality among different institutions. The NCO ratio indicates the annualized percentage of a bank's loans that it ends up writing off as bad debt.
• Price-to-book (P/B) ratio: When valuing bank stocks, the price-to-book ratio can be just as useful as the P/E ratio. The P/B ratio is a company's stock price divided by its net asset value. The price-to-tangible-book-value (P/TBV) ratio may be even more useful than the P/B ratio because it excludes assets tough to value, such as brand names and goodwill.

Two important metrics for analyzing insurance stocks

Two important metrics for analyzing insurance stocks

• Combined ratio: To compute this ratio, first add (combine) the amount of money an insurance company pays out in claims to the amount of money the company spends on other business expenses. Divide that amount by the amount the insurance company collects as premium income. If an insurer is a profitable underwriter, the result should be less than 100%. A lower combined ratio indicates the insurer is generating greater profit.
• Investment margin: Insurers aim to profit from underwriting policies. They also can make money by investing the premiums they collect until they use the money to pay any insurance claims. How profitably an insurer invests -- its investment margin -- is important since investment income is often the primary source of profits for an insurance company. Most insurance companies invest in rather safe fixed-income instruments like Treasuries and corporate bonds.

Related investing topics

Investing in the financial sector for the long term

Investing in the financial sector for the long term

Financial stocks -- especially banks -- can be cyclical, meaning they’re vulnerable to losing value during recessions. When unemployment rises, consumers and businesses often struggle to pay their bills, which can lead to large amounts of bad debt for banks. Banks can be especially vulnerable to panics and crises, which have historically occurred about once a decade (including in early 2023, when several regional banks failed).

Be aware of the risks before investing, and consider the overall outlook for a financial company (not just one or two metrics) when conducting your analysis. Also, remember that financial sector stocks are best suited as long-term investment vehicles. There are many factors that can influence bank stocks over shorter time periods that are very unpredictable.

Many factors can influence financial stock prices in the near term, and many of those factors -- such as weak economic conditions or falling interest rates -- have little to do with the strength of the business itself. If you have an investment time horizon of five years or more, then adding some of the best financial sector stocks to your portfolio is likely a wise choice.

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