Flight to Quality and Asset Allocation in a Financial Crisis

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%.In the recent financial crisis, investors suffered losses on their portfolios on the order of 20%–30%. In addition, they faced a market in which the volatility of most asset classes and the correlations among those asset classes surged, all of which served to greatly increase the risk of their portfolio positions. The challenging issue facing investors was the appropriate tactical adjustment they should make to their portfolio allocations in response to this market dislocation. In this article, the authors argue that the appropriate adjustment for any given investor is determined by equilibrium considerations (supply must equal demand) and depends on that investor’s characteristics relative to societal averages. Although this point should be obvious, it seems to have been ignored by many investors and their advisers. In a simple model calibrated to capture the magnitude of the 2007–09 crisis, the authors show that the optimal tactical portfolio adjustments for most investors are not large, requiring turnover of less than 10%, and that this finding is quite robust to changes in their assumptions.