The financial services sector is widely considered to be the lifeblood of the economy – and it’s therefore uniquely important. When financial firms are healthy, they provide people and businesses with the widespread access to borrowing that’s essential for economic growth. But when the sector grows sick – as during the 2007-08 financial crisis, for example – it can drag down everything and everyone else. What’s more, financial stocks account for more than 10% of the value of the MSCI World market index, meaning they’re likely to form a considerable portion of even the most passive portfolio. In this Pack, though, we won’t just demystify the financial services sector in general – we’ll also show you what to look for when investing in individual financial companies. So without further ado, let’s get started.

How to file financial firms

The financial sector encompasses many different types of firm. Most fall into four main categories, however: banks, investment firms, diversified financial services, and insurance companies.

Banks are financial institutions that take in money in the form of customer deposits and then lend it out again as loans. You could further subdivide such activity into retail banking (deposits from/loans to individuals) and commercial banking (deposits from/loans to businesses). Banks of both types primarily make money by pocketing the difference between the interest rates at which they lend and those at which they themselves “borrow” – i.e. the rates they offer on customer deposits.

Investment firms pool clients’ money and invest it on their behalf across different financial markets. They essentially provide a service, sometimes called asset management (for institutions) or wealth management (for individuals), catering to those who lack the knowledge, time, or desire to invest themselves. Investment firms’ primary source of income is the management fee they charge customers, normally expressed as a percentage of their overall assets under management (AUM). Some companies also charge a performance fee on certain products – often a percentage of the investment profit achieved.

Diversified financials – as you may have worked out from the name – are institutions that offer a wide range of financial services. Big names such as JPMorgan Chase, Goldman Sachs, Barclays, and Deutsche Bank are all examples of this. As well as retail and commercial banking and asset and wealth management, however, diversified financial firms often have investment banking functions as well. This typically involves helping other companies raise financing (including via stock and bond sales) and execute mergers and acquisitions. Investment banks also help investment firms take and implement investment decisions through their research, sales, and trading departments.

Insurance companies, finally, are financial institutions that provide protection against financial loss. Insurance companies are essentially in the business of risk management: they balance the likelihood of something happening against the cost of it coming true, with customers paying firms an appropriate fee to assume risks they can’t afford to run themselves. Insurance companies variously offer coverage in the event of accident, illness, and even death – but seeing as we’ve already got a dedicated Pack on the industry, we’re not going to cover its investment opportunities here.