Flight to Quality: What it is, How it Works

What Is Flight to Quality?

Flight to quality occurs when investors in aggregate begin to shift their asset allocation away from riskier investments and into safer ones, for instance out of stocks and into bonds. Uncertainty in the financial or international markets usually causes this herd-like behavior. However, at other times, the move may be an instance of individual or smaller groups of investors cutting back on the more volatile investments for conservative ones.

Understanding Flight to Quality

For example, during a bear market, investors will often move their money out of equities and into government securities and money market funds. Another example is investors moving investments from high-risk countries with political unrest like Thailand or many thriving yet still not fully established markets like Uganda and Zambia to more stable markets of other countries, like Germany, Australia, and the United States. One indication of a flight to quality is a dramatic fall of the yield on government securities, which is a result of the increased demand for them.

Many investors will monitor for a decrease bond yields as a metric for more challenging economic conditions, including increasing rates of unemployment, stagnating economic growth or even a recession. As interest rates increase, bond prices also tend to fall.

Flight to Quality and Conservative Investment Alternatives

In addition to moving funds from growth stocks, international markets, and other higher-risk-higher-reward equity investments to government securities, investors may choose to diversify their assets with cash holdings. Cash equivalents are investments that can readily be converted into cash and can include bank accounts, marketable securities, commercial paper, Treasury bills and short-term government bonds with a maturity date of three months or less. These are liquid and not subject to material fluctuations in value. (Investors should not expect the value of any cash equivalents to change significantly before redemption or maturity.)

In addition, when markets take a downturn or appear to be taking a downturn, some investors will move their assets into gold. Critics argue that this is a foolish change and that gold does not have the inherent value that it once did, due to decreased industrial demand. At the same time, proponents point out that gold may be helpful during periods of hyperinflation, as it can hold its purchasing power much better than paper money. While hyperinflation has never occurred in the U.S., some countries like Argentina are familiar with the pattern. From 1989-90, Argentina saw inflation hit a staggering 186% in one month alone. In these cases, gold could have the capacity to protect investors.