Liquidity risk can be a risk worth taking

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.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

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.