Trading, the “Flight to Quality” phenomenon

The concept of "flight to quality" is the phenomenon that sees investors move from riskier assets to less risky assets. This phenomenon mainly occurs in periods of recession or when markets are turning towards a negative scenario, therefore investors are looking for quality, i.e. sell risk for security, towards investments that secure their capital.

In this article we will explain what "flight to quality" is and above all why it is such an important concept within the landscape of investments on the financial markets, especially with regards to long-term investments and above all the operations and management of large financial institutions and large market players.

What is "flight to quality"

The "flight to quality" is the phenomenon that involves the movement of capital from riskier assets to less risky assets in order to preserve capital in the long term. This phenomenon mainly occurs in periods in which a deterioration in market conditions or macroeconomic conditions is expected and therefore a radical change in one’s investment choices is required and a shift in the risk of one’s asset allocation, i.e. of one’s portfolio.

In these situations in which a deterioration is expected, large financial institutions and large market players prefer choices that preserve capital by disinvesting in risky assets such as the stock market and preferring less risky assets such as those in the bond market. Academically speaking, the flight to quality is seen as that displacement of liquidity from the stock market, the risk market par excellence, to the bond market which is usually referred to as a "risk free" market.

From this purely theoretical assumption, we can deduce that when the stock market falls and the economic outlook deteriorates, traders start buying bonds. It follows that the fall in the stock market corresponds to a rise in the bond market with a consequent drop in yields due to the increase in the prices of the same market. But this is what happens in theory, therefore we must consider this phenomenon as a logic rather than a concept. Logic therefore predicts that, when the markets start to creak within a recessionary economic scenario, operators begin to move based on risk, i.e. they try to evaluate what is actually risky for capital and then find less risky solutions to preserve the capital.

There are situations where the stock market and bond market are both seen as risky markets, such as in the current situation. To give a current example, this year we have seen very sharp declines on the stock market, the same thing that happened on the bond market where we have seen steeply rising yields on all the most important government bonds for Western economies. Here the "flight to quality" took place anyway but not in the sectors that we usually consider as academically valid.

The "flight to quality", in this case, has spilled over to actual liquidity as the money market now offers good returns with rising interest rates and at the same time security as regards the preservation of capital in the long period. Quality right now is represented by liquidity itself and the market tends to liquidate everything that is risk.

Flight to quality and trading

As can be seen, the concept of risk is always at the center of all decisions regarding investments in the financial markets. The biggest problem always remains the same, understanding which asset is risky at that precise market moment, a difficulty that is faced by the big players with the use of statistical and mathematical models that serve precisely to price assets based on risk. This phenomenon manifests itself not only on long-term investments and on the portfolio choices of large investors, but also on those who trade in the short term.

Following the same logic according to which it is better to move one’s resources from riskier assets to less risky ones, a trader who decides not to trade in a given moment or period of the market, is implementing the "flight to quality”. The decision not to trade represents a choice that provides for safeguarding one’s capital in the face of a subjectively risky market situation for the trader, therefore it is better to stay still, hold liquidity, rather than risk going to the market and taking unmanageable risks.

As you can see, from the phenomenon we pass to logic, a logic that mainly refers to the concept of risk that we have dealt with in previous articles and which must be the cardinal principle according to which investment or trading decisions are made.

While for the short-term trader the flight to quality can be associated with "standing still", when the market is subjectively difficult to read and manage, for large investment funds it is associated with a reversal of portfolio risk. This happens because an investment fund, having invested large amounts on many assets, will find it more difficult to liquidate the invested sums and therefore will use leveraged instruments to hedge against the risk or, if established within the fund’s regulation, can "switch" from riskier to less risky assets keeping a certain percentage of the overall portfolio under management invested.

In this regard, therefore, we can say that this "flight to quality" phenomenon is closely linked to risk management and could be useful in analysis perspective to actually see how the market is perceiving risk. The more the market moves to less risky assets, the more fear operators have about the evolution of prices in the future. This logical assumption can also be used in the current context where all pure risk assets are demobilized in favor of liquidity, real security within the financial system.

Original article published on Money.it Italy 2022-12-29 08:57:00. Original title: Trading, il fenomeno del “Flight to Quality”