During significant market downturns and crashes, many investors flock to safer investment products. However, there are many diverse investment options available, each with a varying level of safety and risk attached.
What Is a Flight to Quality?
A flight to quality, also known as a flight to safety, is a market phenomenon where investors shift their preferences from riskier investment products to those perceived as low-risk. A flight to quality usually occurs at times of market uncertainty, market crashes, or bear markets. Often, these market developments are caused by significant international events, large-scale corporate bankruptcies, major government policy changes, and other events that destabilize financial markets.
A classic example of a flight to quality is when investors divert their funds from stocks and derivatives to gold and government bonds. Investment products with lower risk and lower return profiles become favored during flights to quality. Normally, the riskier the investment product is, the more it suffers during a flight to quality.
What Investment Products Are Considered Low-Risk?
Cash, savings deposits, and US federal government securities are usually considered the safest investment options during flights to quality.
Savings deposits held at accredited banks in the US are covered by the federal government’s insurance, and thus, are considered a very low-risk investment option. In many other OECD economies, savings deposits are also covered by government guarantees.
There are three main securities offered by the US federal government – treasury bills, treasury notes, and treasury bonds. All three are considered very low-risk, and differ mainly in the tenure of the investment commitment and yields. Treasury bills have the shortest tenure of maturity, from 4 weeks and up to 52 weeks. Their yield rates are fixed for the tenure of investment.
Treasury notes have medium-term maturity tenures, from 2 years and up to 10 years. Yield rates on treasury notes are variable and can change on a daily basis.
Treasury bonds are the longest-term government investment product. They have maturities between 10 and 30 years, and pay yield twice a year.
All three kinds of the government securities have relatively very low yield rates, reflecting their highly secure profile. Securities with tenures of under 5 years currently pay below 1% yields, with the 3-month bills paying just 0.05%. The securities with 5+ year tenures pay between 1% and 2% yields.
In addition to cash, deposits, and government securities, many investors also consider gold or real estate as safe investment options during times of market turmoil.
However, both gold and real estate may experience shorter-term volatility and declines during market downturns. Real estate, in particular, has seen declines and instability uncharacteristic of an asset that is considered as low-risk.
Many investors and analysts consider real estate a suitable item only for long-term investing. However, many flight to quality events may be short-term, lasting literally days or even just one day in extreme cases. Thus, real estate, with its longer-term profile, is hardly suitable as a safe asset during such market developments.
Similarly, gold has experienced shorter-term instability or decline when markets turned bearish. Eventually, gold does tend to rise in value during bear markets, but it is poorly suited to short-term flights to safety.
Whether viewed from shorter-term or longer-term lenses, both gold and real estate are considered somewhat riskier than cash, deposits, and government securities.
What Investment Products Are Considered Medium-Risk?
Company stocks, mutual funds, index funds, exchange-traded funds (ETFs) are usually the kind of investment products considered far riskier than deposits, government securities, or gold, but still less risky than derivative-based products, most commodities, or cryptocurrencies.
When it comes to company stocks, there is a large difference in the risk levels between established blue-chip companies, with their relatively low-risk profile, and newer, less established, and riskier companies.
On average, company stocks are somewhat riskier than mutual funds, index funds and ETFs. That is because all these fund varieties spread your investment across a variety of investment destinations, diversifying it, and helping reduce your overall risk via diversification.
Mutual funds invest in a variety of securities, and are actively managed by portfolio managers employed by the funds.
Index funds are a relatively more passive form of investing compared to mutual funds. With index funds, you invest in some composite, and often well-established, index. Since these indices are typically based on an established market product, e.g., S&P 500, index funds represent a lower risk level than mutual funds.
ETFs are in many ways similar to index funds. They also represent a passive investment in a basket of assets. However, unlike index funds, ETFs can be freely traded on exchanges, hence the name. Due to this feature, ETFs are normally considered somewhat riskier than the plain standard index funds.
There is much debate as to whether ETFs are any riskier than mutual funds. In general, with all things being equal, there is no significant difference in the risk factor between ETFs and mutual funds.
During a flight to quality, stocks, mutual funds, index funds, and ETFs may lose investment flying towards the low-risk assets covered in the previous section. However, it takes a very serious market downturn for this scenario to happen on a large scale. Being medium-risk, these asset classes do not suffer as badly as high-risk products. In fact, they may benefit from a flow of funds towards them from high-risk assets when a less severe market downturn occurs.
What Investment Products Are Considered High-Risk?
Typical assets that are viewed as high-risk include derivative-based financial products, most commodities, and cryptocurrencies.
Derivatives are a class of financial products that derive their value, terms, and characteristics from other underlying financial assets, e.g. stocks, market indices, currencies, bonds, or commodities.
Derivatives can be structured in a very complex way, and are often traded via leverage. In some cases, they may be based on highly volatile underlying assets. All these factors make derivatives a relatively high-risk asset class, at least compared to the medium-risk and low-risk products covered in the previous sections.
Commodities, with the exception of precious metals such as gold, silver, and platinum, are considered a volatile and high-risk investment option too. Prices of most commodities can fluctuate wildly due to international political events, disputes between governments, wars, important economic news, bad harvests due to adverse weather, and a large number of other factors.
Much to the disappointment of crypto enthusiasts and blockchain aficionados, cryptocurrencies are also considered a high-risk asset class.
Why Are Cryptocurrencies Considered High-Risk?
- Cryptocurrencies are characterized by wild price swings, both up and down. Many crypto investors have become accustomed and “desensitized” to these wild changes through familiarity with the crypto market. However, to investors used to traditional markets, even the volatile ones such as commodities, typical crypto price charts look like a roller-coaster.
- Cryptocurrencies are minimally regulated and many investors are concerned about their rights and privileges as crypto asset holders in these projects.
- Partly due to little regulation in the industry, cryptocurrencies are prone to receiving frequent unwanted attention from governments. In 2017, the US government got concerned with a wave of crypto ICOs and issued a number of warnings, hinting at tighter regulation to come. The Chinese government has repeatedly cracked down on cryptocurrency projects based in China, with the latest crackdown leading to the closure of some very large crypto mining pools. All these government actions add to the instability of many crypto projects and assets.
- Crypto platforms can abruptly change direction via forking. Some of these forks can cause extreme price swings for the crypto assets involved, or even lead to a subsequent downfall of the project.
- Crypto platforms are susceptible to hacker attacks that can wipe out millions from cryptocurrencies in a matter of seconds. Although cryptocurrencies are based on the relatively secure blockchain technology, a non-trivial number of security breaches have happened in the past, leading to significant value losses.
The Flight to Quality Ladder
Based on the three broad risk categories, low, mid, and high, outlined in the previous sections, here is our “flight to quality ladder”.
The Flight to Quality Ladder
Within each risk category, the products are ranked from relatively riskier at the top, to the less risky ones closer to the bottom. However, it should be noted that the within-category risk ranking is often less discernible and open to interpretation.
For example, we can confidently say that index funds are (in general) a safer asset than cryptocurrencies, but cryptocurrencies may be only marginally riskier than derivatives. For instance, an investment in a volatile derivative product may well be far riskier than an investment in BTC.
In this ladder, the expectation is that funds will flow from the riskier assets at the top to the safer assets down the ladder at times of flight to quality.
Naturally, this flight may skip the ladder sections depending on market developments. For example, if a severe enough market downturn occurs, crypto and derivative holders may shift directly to gold or government securities rather than stocks or mutual funds.
A flight to quality is a market phenomenon when investors flock to lower-risk assets during times of market instability, crashes, or bear markets. The assets that benefit the most during a flight to quality are low-risk investment options such as savings deposits, US government securities, gold, and, to a lesser degree, real estate.
The riskiest assets, cryptocurrencies, derivatives, and most commodities are dumped first by investors when investors fly to quality. During less severe market declines, these asset classes may lose investments flowing towards medium-risk assets – company stocks, index funds, ETFs, and mutual funds.
However, if a severe market crash or a profound bear market arrives, the investments in high-risk and medium-risk assets will fly towards the lowest-risk products on the “flight to quality ladder.”