Flight to Quality Risk Averse Loss Averse what causes a Flight to Quality

“Flight to quality” is an investment market phenomenon that generally occurs in poorly performing or highly erratic financial markets. It is characterized by movement of investment capital away from perceived high-risk investments and into lower risk investments. The movement of capital could take many different forms:

Selling investments in smaller companies to invest in blue chip stocks; selling stock holdings and buying corporate or government bonds; selling investments in international emerging markets and buying high quality domestic equities; selling high credit risk bonds; and investing in government treasuries.

Flights to quality can take many forms, but they all have one thing in common.  They result in a reduction in the overall risk of an investor’s portfolio. Not only is there a reduction in risk, there is also generally an increase in liquidity. Liquidity is simply how quickly an asset can be turned into cash, if needed. For example, a blue chip stock is highly liquid as it can be sold almost immediately by the investor. An investment in a real estate venture, however is generally highly illiquid as it can take months or even years in order to cash out the investment.

What causes a flight to quality?

Large capital movements to low risk investments generally occur in down markets. When investments perform poorly, investors grow tired of accumulating losses. They “cut their losses” and move investment capital into low risk investment vehicles. Investors are generally willing to experience lower expected investments return in order to obtain less chance of loss. Flights to quality also occur when investors are experiencing a highly volatile market. Investors are not only loss averse, they are also volatility averse. If investments become too volatile (even if they perform well), investors will move capital away from highly volatile investments into something more stable.

What is the result of a flight to quality?

If investors are moving capital away from “Investment A” and into “Investment B” in a flight to quality, the end result is inevitable.  Investment A will decline in value while investment B will increase. Investment A will tend to be undervalued compared to Investment B. Unfortunately, most investors will not be able to perceive that a flight to quality is occurring until well after it has started. Selling Investment A to purchase Investment B at this point is too late.

How can an investor take advantage of a flight to quality?

Knowing the inevitable end result can offer the intelligent and patient investor a significant opportunity. After a move has taken place, the relative value of a particular class of investments is undervalued. If the investor knows which security class is undervalued, and has the patience and fortitude to invest in those securities, he or she should earn above market financial returns. As long as the investor remains invested over the long term and does not buy/sell securities too often, they should be able to outperform the market.

Flights to quality are a financial market psychological effect. People are naturally risk and loss averse, so investors behave accordingly. The markets sometimes tend to have the herd effect, where investors act in unison and quickly. These events cause both a risk as well as an opportunity for the intelligent investor.