Investing in stocks comes with the prospect of earning big returns, but it can also carry some considerable risks. At times of financial market stress, investors will often flee from risky assets and into investments that are perceived as very safe. Investors will act as a herd and try to rid themselves of any risk in what is termed a "flight to quality". Whether or not an investor takes part in the flight, it is important to understand the concept, its indicators and its implications for the market.

What is a flight to quality?
A flight to quality occurs when investors rush to less risky, more liquid investments. Cash and cash equivalents, such as Treasury bills and notes, are key examples of the high-quality assets investors will seek. Investors try to allocate capital away from assets with any perceived risk into the safest possible instruments they can find. Investors usually tend to do this en masse and the effects on the market can be quite drastic. (Knowing what the market is thinking is the best way to determine what it will do next. Read Gauging Major Turns With Psychology.)

The Causes
The causes for a flight to quality are usually quite similar, and normally follow or are concurrent with some level of distress in the financial markets. Fear in the market generally leads investors to question their risk exposure and whether asset prices are justified by their risk/reward profiles.

While every market has its own intricacies, most upswings and downturns are somewhat similar: a sharp downturn follows what, in retrospect, were unjustifiable asset prices. A lot of the time the asset prices were unjustified because many risk factors such as credit problems were being ignored. Investors question the health of companies they are invested in and may decide to take profits from their riskier investments, or even sell at losses in order to move into lower-risk alternatives. Unfortunately, most investors don't get out at the early stage. Many join the flight to quality after things start to turn sour and leave themselves open to even bigger losses. (The option to bolster after-tax stock returns through tax-loss harvesting can reverse investor gloom. Check out Tax-Loss Harvesting For An Unsteady Market.)

Once major issues in the market come to light, the bubble begins to burst and panic occurs in the market as participants reprice risk. Sharp declines in asset prices add to the panic, and force people to flee toward very low-risk assets where they feel their principal is safe, without regard for potential return. A flight to quality is often a pretty abrupt shift for financial markets; as a result, indicators such as fear and shrinking yields on quality assets aren't noticed until the flight has already begun.

Negative T-Bill Yield
An extreme example of a flight to quality occurred during the 2008 credit crisis. U.S. T-bills are perceived as some of the highest quality, lowest risk assets. The U.S. government is considered to have no default risk, meaning that Treasuries of any maturity have no risk of principal loss. T-bills are also issued with maturities of 90 days, so the short-term nature makes interest rate risk minimal, and, if held to maturity, non-existent.

T-bill interest rates are largely dependent on the federal funds target rate. When the Federal Reserve consistently lowered rates during 2008, eventually setting the federal funds target rate at a range of 0-0.25% on December 16, 2008, T-bills were certain to follow the trend and return next to nothing to their owners. (For more on T-bills, see the Money Market Tutorial.)

But, could they actually return less than nothing? As the flight to quality drove institutions to shed any sort of risk, the demand for T-bills quickly outpaced supply, even as the Fed was quick to create new supply. After taking a bloodbath in nearly every asset class available, institutions tried to close their books with only the highest, most conservative assets (aka T-bills) on their balance sheets. (Learn about the components of the statement of financial position and how they relate to each other in Reading The Balance Sheet.)

The flood of demand for T-bills, which were already trading at near-zero yields, caused the yield to actually turn negative. On December 9, 2008, investors bought T-bills yielding -0.01%, guaranteeing that they would receive less money three months later. Why would any institution accept that? The main reason is safety. If an institution bought $1 million worth of T-bills at the -0.01% rate, three months later their loss would about to about $25. (For more on what happened, see Why Money Market Funds Break The Buck.)

In a time of market panic and flight to quality, investors will take that very small nominal loss in exchange for the safety of not being exposed to the larger potential losses of other assets. Negative T-bill yields are not characteristic of every time the market experiences a flight to quality, but an extreme case of where demand forces down the yields of high-quality assets. (Learn more in The Fall Of The Market In The Fall Of 2008.)

Don't Panic
A flight to quality is logical to a certain point as investors reprice market risk, but can also have many adverse consequences. First, it can help exacerbate a market downturn. As investors grow fearful of stocks that have experienced sharp declines, they are more inclined to dump them, which helps worsen the decline. Investors suffer again as their fear will prevent the buying of risky assets, which after the declines may be very attractive. The best thing for an investor to keep in mind is to not panic and be the last person selling their stocks and moving into cash when stocks are likely hitting lows.

The consequences read through to businesses also, and can affect the health of the economy, possibly prolonging a downturn or recession. During and following a market crash and flight to quality, businesses may grasp cash similar to investors. This low-risk, fear-driven strategy may prevent businesses from investing in new technologies, machines, and other projects that would help the economy.

Conclusion
Just like with bubbles and crashes, a flight to quality of some degree during a market cycle is pretty much inevitable, and impossible to prevent. As investors become jaded with the risky assets, they will seek out one thing and one thing only: safety.

Is there a way to profit from a flight to quality? Not unless you can predict what everyone else will do and do the opposite. Even then, you need to time it perfectly to avoid being trampled by the herd. It may be hard, but don't panic. (For a broader look, read Examining Credit Crunches Around The World.)

Related Articles
  1. Fundamental Analysis

    3 Misconceptions About Warren Buffett

    Learn why Warren Buffett is the man behind the curtain and how he is misunderstood regarding the ways he has adapted and changed his investing approach over the years.
  2. Investing News

    Latest Labor Numbers: Good News for the Market?

    Some economic numbers are indicating that the labor market is outperforming the stock market. Should investors be bullish?
  3. Investing News

    Is the White House too Optimistic on the Economy?

    Are the White House's economic growth projections for 2016 and 2017 realistic or too optimistic?
  4. Products and Investments

    Cash vs. Stocks: How to Decide Which is Best

    Is it better to keep your money in cash or is a down market a good time to buy stocks at a lower cost?
  5. Economics

    Can the Market Predict a Recession?

    Is a bear market an indication that a recession is on the horizon?
  6. Investing

    3 Healthy Financial Habits for 2016

    ”Winning” investors don't just set it and forget it. They consistently take steps to adapt their investment plan in the face of changing markets.
  7. Investing

    How to Ballast a Portfolio with Bonds

    If January and early February performance is any guide, there’s a new normal in financial markets today: Heightened volatility.
  8. Economics

    The Truth about Productivity

    Why has labor market productivity slowed sharply around the world in recent years? One of the greatest economic mysteries out there.
  9. Investing News

    Today's Sell-off: Are We in a Margin Liquidation?

    If we're in market liquidation, is it good news or bad news? That party depends on your timeframe.
  10. Stock Analysis

    Why the Bullish Are Turning Bearish

    Banks are reducing their targets for the S&P 500 for 2016. Here's why.
RELATED FAQS
  1. What is finance?

    "Finance" is a broad term that describes two related activities: the study of how money is managed and the actual process ... Read Full Answer >>
  2. What is the difference between positive and normative economics?

    Positive economics is objective and fact based, while normative economics is subjective and value based. Positive economic ... Read Full Answer >>
  3. What's the difference between a stop and a limit order?

    Different types of orders allow you to be more specific about how you'd like your broker to fulfill your trades. When you ... Read Full Answer >>
  4. Are secured personal loans better than unsecured loans?

    Secured loans are better for the borrower than unsecured loans because the loan terms are more agreeable. Often, the interest ... Read Full Answer >>
  5. Which mutual funds made money in 2008?

    Out of the 2,800 mutual funds that Morningstar, Inc., the leading provider of independent investment research in North America, ... Read Full Answer >>
  6. Does mutual fund manager tenure matter?

    Mutual fund investors have numerous items to consider when selecting a fund, including investment style, sector focus, operating ... Read Full Answer >>
Hot Definitions
  1. Harry Potter Stock Index

    A collection of stocks from companies related to the "Harry Potter" series franchise. Created by StockPickr, this index seeks ...
  2. Liquidation Margin

    Liquidation margin refers to the value of all of the equity positions in a margin account. If an investor or trader holds ...
  3. Black Swan

    An event or occurrence that deviates beyond what is normally expected of a situation and that would be extremely difficult ...
  4. Inverted Yield Curve

    An interest rate environment in which long-term debt instruments have a lower yield than short-term debt instruments of the ...
  5. Socially Responsible Investment - SRI

    An investment that is considered socially responsible because of the nature of the business the company conducts. Common ...
Trading Center