Flight to quality describes how investors react and manage their portfolios during periods of stock market volatility. This strategy favors more conservative investments in lieu of riskier ones. Here’s what flight to quality means and how it can potentially impact your investment portfolio.
Flight to Quality Defined
Simply put, flight to quality moves some of your investment capital from riskier investments to more conservative ones. It reacts to periods of market volatility or economic uncertainty. Also known as flight to safety, this strategy abandons riskier investments and minimizes potential losses in shaky markets. Once the market stabilizes, you can review your asset allocation and readjust to meet your investment goals.
How Flight to Quality Works
Flight to quality describes a pattern of investor behavior. However, it’s typically driven by larger factors that can impact the U.S. and global stock markets. For example, a change in the yield curve hinting at recession could trigger a flight to quality. However, political or economic changes in other countries also influence a flight to quality.
The mood of the market during volatility can affect this strategy. For example, in 2007 and 2008, numerous investors fled mortgage-backed securities ahead of the housing crisis. On a smaller scale, a flight to quality or safety can involve investors curbing risk in their portfolios.
Buying and Selling
A flight to safety varies for everyone. However, it generally focuses on trading higher-risk investments for lower-risk ones. For example, an investor worried about economic decline might sell growth stocks in favor of more reliable blue-chip stocks. A flight to quality may also shift investment shift from foreign or emerging markets to domestic stocks. Meanwhile, it also can shift investors from junk bonds to high-quality corporate bonds or Treasury bonds.
Investors can bolster their portfolio with safer cash investments. Such options include money market funds or certificates of deposit. While these investment vehicles vary, each insulates against risk or other negative factors. For instance, inflation can hinder a portfolio. As prices for consumer goods rise, the purchasing power of investments shrinks. Shifting to more inflation-safe investments, such as Treasury Inflation-Protected Securities, can decrease risk.
Flight to Quality and Your Portfolio
A flight to quality can protect your investments against volatility. However, seeking less risk comes with a downside.
Say you’ve been investing in growth stock mutual funds. They have a higher risk profile but can deliver better returns than something like a value stock. If you move away from growth stocks and invest in value instead, then your portfolio’s return potential could shrink. Value stocks typically buy and hold securities for the long term. As a result, you don’t necessarily see big returns right away. On the other hand, you may get some income if you’re investing in value stocks that pay dividends.
A flight to quality can also translate as a flight to liquidity. Consequently, they are investments that are easier to liquidate and sell. Having more of your portfolio in liquid investments might help if you’re worried about converting assets to cash quickly.
Changing asset allocation could affect returns in the short-term. But if you’re more concerned with preventing losses than making big gains, then this strategy could make sense.
Meanwhile, flight to quality can work in reverse during strong markets. When markets stabilize, confident investors might seek riskier investments. Doing so capitalizes on the momentum in the stock market. For example, an investor might move more of their assets into growth stocks or alternative investments, such as cryptocurrency. Meanwhile, they can reduce investment in dividend-producing stocks or other fixed income investments.
The Bottom Line
Every investor encounters volatility at some point. The stock market tends to move in natural cycles. When volatility begins to increase, a flight to quality can occur as investors attempt to downplay risk in their portfolios. While this action can insulate against risk, it’s important to consider how it might affect your returns and your bigger investment picture.
- Consider talking to your financial advisor about a flight to quality if you’re worried about the market. Your advisor can review your portfolio and help you develop a strategy for dealing with market fluctuations. Finding the right financial advisor that fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in 5 minutes. If you’re ready to be matched with local advisors that will help you achieve your financial goals, get started now.
- Investing in bonds or treasuries may seem like an obvious choice if volatility prompts you toward a flight to quality. But it’s important to understand how interest rate movements can affect bond prices and yields. When interest rates are rising in a growing economy, then bond prices fall. When interest rates drop, which can happen when the Federal Reserve is attempting to stimulate the economy by making borrowing more accessible, prices rise. This inverse relationship can directly affect the yield you see on the bonds in your portfolio. Depending on which way rates are moving, you might be better off holding short-term maturity vs. long-term maturity bonds or vice versa. Knowing what kind of bonds you own and which ones are the best options for volatile markets can help you shape your strategy if a flight to quality seems necessary.
Photo credit: ©iStock.com/oatawa, ©iStock.com/Johnce, ©iStock.com/dima_sidelnikov