The Sector Strategist: Using New Asset Allocation Techniques to Reduce Risk and Improve Investment Returns

CHAPTER 7

The Financial Sector

I'd like to live like a poor man with lots of money.

Pablo Picasso

The financial services industry is an important facilitator of economic activity. The primary function of any financial institution is to expedite the exchange of financial resources between savers and borrowers. The financial services sector includes five sub-sectors: banks, insurance companies, consumer financial services, securities companies, and S&Ls. Overall, the financial sector includes more than 5,400 stocks. The sector represents 14.8% of the market capitalization of the S&P 500, making it the third largest sector of the index. As a result of the financial crisis of 2008, the sector lost much of its luster. At one point in 2006, the sector accounted for over 21% of the S&P 500.

Despite the poor performance in the sector in the most recent bear market, the category's returns are still above average and are impressive for the long term. For the 24-year period ending December 31, 2010, the sector generated a 9.51% annualized return. Remarkably, a substantial proportion of the category's long-term gains have come not from small, high-risk companies, but from established, highly visible, and financially sound firms such as Wells Fargo, Goldman Sachs, and Chubb.

Sectoral Factors

I believe there are three distinctive characteristics that favor owning financial firms:

• Global demographic changes
• Globalization trends
• Continued low interest rates

The combination of these factors ...