A Primer on Flight to Quality

"Flight to quality" has nothing to do with a nice vacation spot. (If that's what you're looking for, check out The Good Life on TheStreet.com.) It is a term, however, that's often thrown around in the investment world. And even though many investors may have heard of a "flight to quality" in passing, how many actually know what a flight to quality is and what effect it can have on their investments? Do you?

What Is Flight to Quality?

Simply put, a flight to quality is when investors unload riskier investments in favor of more "stable" ones. Typically, this occurs when investors are concerned about the future economic situation and want to put their money somewhere less volatile. Economic uncertainty is usually the primary reason for a flight to quality.

On average, a flight to quality is a widespread move, though it can be applied to single investors as well. An investor involved in highly risky investments like penny stocks would be making a flight to quality if he or she decided to sell the penny stocks in favor of municipal bonds. The municipal bonds are "better quality" because they're less prone to market price movement, so are considered more stable.

How Does a Flight to Quality Occur?

As in the example, a flight to quality doesn't have to stick to one asset class (although it can). A flight to quality could be from a small-cap stock like Crocs ( CROX) to a "blue chip" name like Apple ( AAPL), from a stock to a money market account, or from a junk bondto a government bond. As long as the investor is moving money from a type of investment with more risk to one with less risk (see "Allocate Your Assets Like a Pro"), you're looking at a flight to quality on some scale.

When Can a Flight to Quality Occur?

As mentioned earlier, a flight to quality happens when there's siginificant uncertainty in the economy. This can be uncertainty with the prospects of a particular stock, sector or with the economy as a whole.

When you sell off shares of an "unruly" stock, that movement from equities (the stock) to cash (the proceeds) sort of constitutes a flight to quality (though this shouldn't be confused with selling stock to collect capital gains).

On a large scale, investors saw a flight to quality after mid-2000 when the technology bubble burst and investors began seeking refuge from losses en masse.

What Happens to Investments In-Flight?

We can understand the rationale behind a flight to quality -- getting away from riskier investments to secure your money -- but what do these movements actually accomplish? Well, flights to quality are experiments in psychology that actually tend to be self-fulfilling prophecies in a couple of ways. Here's how.

Let's say you own stock in an up-and-coming movie studio whose next release is "sure" to be a hit. One problem: The movie's a flop, and your studio is stuck between a rock and a hard place.

Naturally, most everyone who owns a piece of the studio is going to want to get out before the company has a chance to announce the awful earnings that it will surely see this quarter, so investors sell off shares of the small studio in favor of a blue-chip entertainment conglomerate. That's our flight to quality.

Market pressure drives the little guy's share price straight down, and all the added interest in the conglomerate will (if anything) bump the share price up a bit, leaving the early doubters the few that actually do well in this situation. When a flight to quality happens, it can be a hard thing to turn around.

Flight to Liquidity

It's hard to mention the term flight to quality without bringing up flight to liquidity. A flight to liquidity is when investors move from investments that are harder to sell (less liquid) to those that are more readily sellable (more liquid). Cash and government bonds are examples of very liquid assets.

Flight to quality and flight to liquidity are can be very interrelated in the stock market because, generally speaking, assets of higher quality also often have a higher level of liquidity. That said, flights to liquidity can have the same investment and market effects as flights to quality.

Learning to Fly

Understanding the effect these "flights" can have on the value of a stock or bond is pretty important as an investor. Markets drive prices for these kinds of investments and knowing how market sentiment will affect your portfolio is a big deal. Now that you understand how investments behave during a flight to quality or liquidity, you should be better prepared for the next big shift in market mind-set (and money).

Jonas Elmerraji is the founder and publisher of Growfolio.com, an online business magazine for young investors.

More from Investing

Market Can't Handle the Wild Ride: Cramer's 'Mad Money' Recap (Thursday 5/24/18)

Market Can't Handle the Wild Ride: Cramer's 'Mad Money' Recap (Thursday 5/24/18)

Musk's Tweets About Unions Draw Fire From United Auto Workers

Musk's Tweets About Unions Draw Fire From United Auto Workers

Replay: Jim Cramer on North Korea, Oil Prices, Apple and Carnival Corporation

Replay: Jim Cramer on North Korea, Oil Prices, Apple and Carnival Corporation

Gap Drops After Hours on Disappointing Earnings, Weak Same-Store Sales

Gap Drops After Hours on Disappointing Earnings, Weak Same-Store Sales

Canopy Growth: First Cannabis Firm on the NYSE Fails to Generate Buzz

Canopy Growth: First Cannabis Firm on the NYSE Fails to Generate Buzz