How the Liquidity Premium Varies in Good Times and Bad Times
For stock and bond market investors, liquidity risk is the risk an investment can't be bought or sold quickly enough to prevent or minimize a loss. The size of bid-offer spreads and the amount of daily volume are often used as indicators of liquidity risk. The academic literature includes many studies showing that liquidity risk is priced into expected returns -- investors require higher expected returns for stocks with higher bid-ask spreads to offset higher trading costs.
Intuitively, we should expect liquidity risk to be priced very differently during good economic times and bull markets (such as the 1990s) than in times of crisis and bear markets (such as 2008). The authors of the 2010 study "Pricing Liquidity Risk and Cost in the Stock Market," investigated whether this intuition is correct.
The authors used historical daily data from Bloomberg from January 2004 through March 2008 for each of the stocks in the S&P 500 Index as of May 1, 2009. They found that the S&P 500's most liquid stocks (usually also the largest) on average earned an annualized liquidity risk premium of 0.3 percent to 0.4 percent. The annualized liquidity risk premium was much higher for the least liquid stocks (usually small market caps), at an average level from 1.5 percent to 2.0 percent. However, over the long term, the premium on liquidity risk was around 0.2 percent to 1.2 percent. They added this caution: "It should be noted that these estimations above are based on our imperfect model and thus may not correctly reflect the true level of liquidity risk premium, especially the premiums in such a crisis period when the asset-pricing mechanism may deviate strongly from its long-term equilibrium."
The authors also found that stock returns are more sensitively linked to both the expected and the unexpected part of illiquidity cost in the crisis period -- the market requires a higher premium for the sacrificed liquidity in such a negative environment. Investors holding illiquid stocks become liquidity takers (if they need to sell them, either to meet liquidity needs or due to panicked selling) and pay a steep price to do so.
Of course, there's another side to the story. Investors who can provide liquidity during such periods benefit by earning a larger liquidity premium. For example, a small-cap or emerging market mutual fund that must sell stocks to meet redemption demand will pay a steep price to trade. Patient buyers (such as Warren Buffett) on the other side of the trade earn larger liquidity premiums during such periods.
The authors also found that unexpected illiquidity costs always have a larger influence on excess return than expected illiquidity costs, in both boom and crisis. Their explanation is that investors react more forcibly to the unknown liquidity shocks. Thus, an additional premium is required for the cost embedded in the unexpected part of illiquidity.
There are important lessons you should take from this study. The first is that since liquidity tends to decline together with return, liquidity risk should be of serious concern when designing your plan. The second is that you should also account for liquidity risk when choosing your specific investments, be they individual stocks or mutual funds.
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