Flight to Quality and Asset Allocation in a Financial Crisis

  • Terri Marsh and Paul Pfleiderer
  • Financial Analyst Journal, 2013
  • A version of this paper can be found here or here.
  • Want to read our summaries of academic finance papers? Check out our Academic Research Insight category

What are the Research Questions

With the current market conditions and the wild ride we’ve all been on, we’ve pivoted our attention to focus on supplying academic research on responding to a crisis. This article investigates what the appropriate tactical adjustments investors should consider when making changes to their portfolio holdings following large losses in wealth during a crisis.

What are the Academic Insights?

In a crisis the typical response by investors is a flight to safety. However, in the zero-sum game of trading equities, for every dollar chasing safety there is an equal number of dollars moving aggressively to take on risk. Thus, in a crisis only a subset of investors can flee to safety.

By considering how the simple economics of supply and demand play out in a situation where both risk and risk aversion have increased significantly, the authors developed a very simple model calibrated to capture the stylized facts that describe the recent crisis, and within that model, they considered how investors should trade among themselves as conditions change.

The authors observe the following:

  1. When the extremely high- and low-risk-tolerant investors do not make up a big portion of investors, the appropriate tactical response for most investors in a crisis can actually be rather small. Specifically, in the base of the analysis with no differences in investor expectations, the authors found that for 80% of the investors, the appropriate adjustment involves less than 4% turnover. Only investors who are extremely risk-averse or risk-tolerant will find it appropriate to make significant changes in their allocations.
  2. Once you introduce grounds that allow for more divergent expectations by investors in the crisis scenario, or if some investors follow a target weight allocation policy that induces extra trading “on autopilot,” then turnover will naturally be higher. Also, if there is much greater heterogeneity among investors in their risk tolerances, there will be a higher demand for trading between very risk-tolerant and very risk-intolerant investors again, with increases in turnover.

Why does it matter?

This study not only highlights that the appropriate action is minimal adjustments by most investors during a crisis, but also discusses the importance of the supply and demand principle in asset allocation. Any tactical portfolio adjustments that investors wish to make in response to changed market conditions take place in a market where the laws of supply and demand govern, and tactical responses must be developed with that in mind. In a crisis, prices and risk premiums must adjust so that, as a rough approximation, one can say that the “average investor” will not want to trade. The trades that any particular investor will want to make depend on how that investor’s risk preferences and other characteristics compare with those of the average investor.

The Most Important Chart from the Paper:

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index.


With respect to the recent financial crisis, the authors argue that the appropriate adjustments to portfolio allocations in response to the market dislocation are determined by equilibrium considerations (supply must equal demand) and depend on individual investors’ characteristics relative to societal averages. Using a simple model that captures the magnitude of the recent crisis, the authors show that the optimal tactical adjustments for most portfolios require a turnover of less than 10%.