Flight to quality, also known as flight to safety, is when investors shift their assets away from riskier investments — like stocks — into conservative securities – like bonds. This reaction often occurs during turbulent times in the economy or financial markets, and investors want to put their money into relatively safe assets.
Because flight to quality is a term that’s often thrown around in the financial media, investors need to know what it is and how it can potentially impact an investment portfolio. A flight to quality is a short-term trading strategy that might not be ideal for long-term investors. But it’s still important for investors to know how the broader trend affects the financial markets.
What Causes Flight to Quality?
Economic uncertainty is why investors look to rejigger their portfolios away from volatile investments to conservative ones. Moments of economic uncertainty that spook investors can arise for various reasons, including geopolitical conflict, a sudden collapse of a financial institution, or signs of an imminent recession.
A flight to quality usually refers to a widespread phenomenon where investors shift their portfolio asset allocation. This large-scale change in risk sentiment can generally be seen in declines in stock market indices and government bond yields, as investors sell risky stocks to put money into more stable bonds.
Though a flight to quality usually refers to a herd-like behavior of most investors during economic uncertainty, individual investors can make a similar move at any time, depending on their risk tolerance and specific financial situation.
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What Are the Effects of Flight to Quality?
During periods of flight to quality, investors trade higher-risk investments for lower-risk ones. This shift commonly results in a decrease in the price of high-risk assets and boosts the price of lower-risk securities.
As mentioned above, investors can see one effect of a flight to quality in the price of major stock market indices and bond yields, as the market shifts money from the risky stocks to safer bonds.
But a flight to quality doesn’t mean that investors will necessarily shift out of one asset (stocks) into another (bonds). For example, investors worried about the economy might sell growth stocks in favor of more reliable value or blue-chip stocks, pushing the price of the growth stocks down and boosting the price of the blue chips.
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A flight to quality may also shift investment from emerging market stocks to domestic stocks or from corporate bonds to government bonds.
In addition to moving funds from stocks to bonds or other assets, investors may also move money into cash and cash-equivalent investments, like money market funds, certificates of deposit, and Treasury bills, during periods of economic uncertainty. These cash investments are very liquid and will not usually fluctuate in value, making them ideal for investors that desire stability.
Real-World Example of Flight to Quality
A flight to quality occurred during the early stages of the Covid-19 pandemic and related economic shutdowns. Investors scrambled to figure out their portfolio positions in the face of an unprecedented global event, selling stocks and putting money into relatively safe assets.
The S&P 500 Index fell nearly 34% from a high on Feb. 19, 2020, to a low on Mar. 23, 2020, as investors sold off equities. But investors didn’t rush to put this money into high-grade corporate and government bonds, as many would have thought in a regular flight to quality. A record $109 billion flowed out of fixed-income mutual funds and exchange-traded funds (ETFs) during a single week in March 2020. Instead, investors moved capital into cash and cash-like assets during this volatile period in a desire for liquidity.
A widespread flight to quality that creates volatility in the financial markets can be scary for many investors. When you see decreases in a portfolio or 401(k), it can be tempting to follow the broader market trends and shift your asset allocation to safer investments. However, this is not always the best choice, especially for investors trying to build long-term wealth.
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