Liquidity risk can be a risk worth taking

Liquidity risk doesn't get a lot of attention, says Matthew Partridge. But properly understood, it can boost your returns.


Don't get caught out of liquidity dries up
(Image credit: SteveAllenPhoto)

Investing involves many risks. Volatility (the frequency and magnitude of price movements) is one form of risk. Credit risk the danger of a company going bust is another. One type of risk gets far less attention than either of these. Yet understood properly, it could help you to boost your returns or avoid big mistakes. We're talking about liquidity risk. Liquidity refers to how easilyyou can buy or sell a given asset.

For example, you'd expect to be able to buy or sell a FTSE 100 share easily. The "bid/ask spread" the gap between the price at which you can buy and the price at which you can sell should be very narrow. Even if you bought it then sold immediately, you wouldn't expect to lose much. A tightly held, small Aim stock would be much harder to trade. The spread could be several percentage points, and a large buyer or seller will almost certainly move the price against them. So it's hard to get out rapidly.

Those are dangers that every investor needs to be aware of. But in theory, those who take greater risks should be rewarded with greater returns. So can taking liquidity risk pay off? The evidence suggests so several studies show that stocks with larger spreads deliver higher returns.

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Yakov Amihud of NYU and Stanford's Haim Mendelson found that between 1961 and 1980 stocks with a relatively large 1.5% spread returned more than 0.45% a month extra above the wider market. And in general, stocks with higher spreads outperformed, though beyond a certain level (4%) the additional positive impact was marginal.

Investing in even less-liquid assets such as unlisted companies can deliver even greater returns. A study of over 1,500 funds by Cambridge Associates found that, from 1981 to 2014, early-stage venture-capital funds made an average of more than 20% a year, compared with around 12% a year for the stockmarket. Professor Roger Ibbotson of Yale University has even discovered that taking liquidity into account at least partly explains why small-cap, value and momentum strategies all beat the market over time. He also found that buying low liquidity stocks boosted returns for both large and small stocks.

So, if less liquid stock and assets beat the market, should you automatically invest in them? In short, it depends. If you don't need the income now, and can sit tight while the asset swings in value, then yes, focusing on such assets makes sense.

But before considering such a strategy, make sure that you have enough cash in liquid assets to access in emergencies and to meet your immediate needs.You never want to be placed in a position where you have to take any price on offer simply to get out of an illiquid position.

Dr Matthew Partridge

Matthew graduated from the University of Durham in 2004; he then gained an MSc, followed by a PhD at the London School of Economics.

He has previously written for a wide range of publications, including the Guardian and the Economist, and also helped to run a newsletter on terrorism. He has spent time at Lehman Brothers, Citigroup and the consultancy Lombard Street Research.

Matthew is the author of Superinvestors: Lessons from the greatest investors in history, published by Harriman House, which has been translated into several languages. His second book, Investing Explained: The Accessible Guide to Building an Investment Portfolio, is published by Kogan Page.

As senior writer, he writes the shares and politics & economics pages, as well as weekly Blowing It and Great Frauds in History columns He also writes a fortnightly reviews page and trading tips, as well as regular cover stories and multi-page investment focus features.

Follow Matthew on Twitter: @DrMatthewPartri