Why is the finance industry so lucrative?


4

Why is the finance industry so lucrative ?

According to Yahoo Finance, the finance sector has by far the largest market capitalization of all sectors. And yet, I have a hard time understanding why finance is so much more valuable to us than say, health care or technology (assuming market capitalization is a fair metric of what's valuable to us).

What real value is produced by this sector ?

Finance Industry

asked Mar 14 '10 at 22:54
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Olivier Lalonde
2,753 points
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4 Answers


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If you want to look at value, think of all the individual wealth created by the public markets. Think of all the incredible businesses that exist because of venture capital. Think of all entrepreneurial vigor stimulated through M&A and Private Equity activity. The desire to make money is what fuels American innovation, and the financial markets are the engine that make it possible.

answered Mar 15 '10 at 03:57
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Doug G
446 points
  • Venture Capitalists - this one I can understand. But what about day traders? As far as I know, they analyze graphs, try to spot trends and invest at the right time... Unlike VCs, they don't have a real insight in what they invest in. – Olivier Lalonde 10 years ago
  • Day Traders help supply liquidity into the markets. When your public company needs no-cost capital to expand operations, hire employees and increase value, you'll be thankful they are there. – Doug G 10 years ago
  • What does real insight have to do with it? If your uncle Bob seeds your venture because he likes you, does it make it any less valuable? – Jeff O 10 years ago
  • @Jeff Oresik: Assuming we're talking about the economic definition of value, I would say so. If uncle Bob would invest his money wisely as opposed to giving money to people he likes, he'll have a better ROI and more value will be created. – Olivier Lalonde 10 years ago

3

The main value comes from facilitating the allocation of capital to sectors such as health care and technology and in enabling people to "time shift" their investment and use of capital. In other words, when you are young and buy a house with a big mortgage, you're using other people's capital. As you get older and (in theory) have saved for your own retirement, you've paid down your mortgage and you've become a source of capital for others.

Part of the reason for the large scale of this sector is that pretty much every company as well as most individuals have significant needs for financial services and this need increases as the size of the company or the individuals portfolio increases.

The "lucrative" aspect stems from a few factors - first, you can charge fees based on your expertise, your processes, your own capital, and your ability to raise capital from various sources. Second, companies and individuals are willing to pay for specialized expertise when it can enable new value for the company or individual - for example - if you need to manage currency in 14 countries, you may find it quite helpful and valuable to have an experienced partner assisting you with the strategy and necessary transactions. Third, there can be a non-linear relationship between input and output. In other words, the effort required to manage a $100M transaction is not 100X the effort to manage a $1M transaction.

In theory, competitive pressures should force the rates for a $100M transaction to be more in line with the effort required and thus decrease the margin. However, there's a significant "reputation" factor here - if you're on a board and you're involved with a $100M transaction and Goldman Sachs says their fee is $2.5M and another firm with zero reputation says they can do it for $1.5M, you're likely to pick Goldman to avoid any future potential risk to you if there were to be a problem with the transaction.

Nice work if you can get it!

answered Mar 14 '10 at 23:46
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Warren E. Hart
2,181 points
  • Good (conventional) answer. I find it kind of sad that moving a few bits from computer X to Y is worth $2.5M to some people. I know it's all about managing risk but still, it leaves me perplex... – Olivier Lalonde 10 years ago

3

You're equating "has the biggest market cap" with "is the most valuable." Not true!

"Has the biggest market cap" simply means "Is capable of generating the most amount of money." Health care, for example, generates health and tries to generate money. Clearly the former is more important than the latter, but the market cap of a health company isn't proportional to the amount of people they help but rather how profitable they might be and how they might be able to grow as a company.

So the right question would be: Why are pure-finance companies more able to produce money than other types of companies?

When phrased that way it's a little more obvious -- it's because they trade in money. The only thing they're responsible for doing is making money -- not making money by providing a valuable service.

At the same time, it's sad. After all, besides the "provides loans" argument above, no they do not produce anything of value, and it's sad that so many brilliant people go into moving paper around instead of inventing medical simulators that might yield the cure for cancer.

answered Mar 15 '10 at 07:34
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Jason
16,231 points
  • Equating "has the biggest market cap" with "is the most valuable." was indeed an over-simplistic generalization (although in economics *theory*, money should = value). That being said, I agree with you about pure finance companies making disproportionate amounts of money vs real value produced. Our system isn't perfect and perhaps there's an opportunity here for an entrepreneur to fix finance :D – Olivier Lalonde 10 years ago

1

I think this has been answered already but 2 points also worth making:

  1. The industry is heavily regulated and licensed, meaning there are high barriers to entry and thus high profit margins.
Also, many transactions are "leveraged", for example an investment of $2000 may be multiplied into $50,000, giving a massive pay-off - or a massive loss. During boom times there's lot of big pay-offs.

And don't forget that banks create money out of thin air (look it up, I'm serious)

  1. There IS a value in what speculators do, though unlike a butcher's pork chop it's not so obvious. Question - how much is a pork chop worth? To know you'd need to check the "price", right? Obviously the value to YOU is subjective but things have prices.
The entire world's economy relies almost entirely upon the pricing mechanism. Without prices it's pretty much impossible to operate any business (or economy) for long. Ludwig von Mises pointed that out as the logical reason the Soviet Union would fail, long before it did.

Speculators, such as day traders, lubricate the pricing mechanism and keep things running a lot better than they would otherwise. Like the butcher they don't do so out of the kindness of their hearts; they do so for profit. Thing is, when people do things for profit they invariably help other people - yep, even day traders :o)

AC

answered Nov 17 '10 at 14:56
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Alan C
66 points

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