Illiquidity and Stock Returns: Cross-Section and Time-Series Effects
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What they found
Amihud proposed a simple illiquidity measure, the average absolute daily return divided by daily dollar volume, that can be computed for any stock from daily data. Using NYSE stocks from 1963 to 1997, he showed that illiquid stocks earn higher expected returns as compensation for their trading costs, and that when market-wide illiquidity rises unexpectedly, stock prices fall, especially for small stocks. Liquidity is therefore both a characteristic that is priced and a risk factor.
What you can use
- Part of the return premium on small and obscure stocks is compensation for the cost and risk of trading them.
- The Amihud ratio (how much price moves per dollar traded) is a practical way to gauge how much your own trading will move a stock.
- Liquidity dries up market-wide in crises, so illiquid holdings fall the most exactly when you need to sell.
Caveats
The measure is crude and is affected by price level and volume conventions. The illiquidity premium has been weaker in recent decades.
Tags: microstructure, liquidity, transaction-costs, factor
Summaries are our own reading of the paper, not the authors' words. Educational only, not advice. Discuss it in Book Club.