Liquidity is an important factor in asset pricing. For both stocks and bonds, the lower the liquidity of an asset (that is, the higher the cost of trading it), the higher the return it is expected to yield. This does not necessarily mean that investors are better off holding assets with low liquidity, because higher transaction costs can eat up return gains. Only investors with long holding periods benefit from holding low-liquidity assets.
When designing an investment portfolio, a portfolio manager should consider not only the client’s risk aversion, but also its investment horizon. A short horizon calls for investing in liquid assets, whereas a long investment horizon enables the investor to earn higher net returns by investing in illiquid assets. The analyst can quantify this liquidity–return tradeoff in light of the client’s investment horizon. Financial analysts should also consider how changes in assets’ liquidity will affect asset values.
Given the negative effects of illiquidity on asset prices, liquidity should affect the design of publicly traded securities. The more liquid a financial instrument, the higher the price for which it can be sold. Liquidity considerations should also affect financial policies. Companies whose claims are traded in the capital market can benefit by undertaking steps to increase the liquidity of their claims, thus reducing their cost of capital. Public authorities can help reduce the cost of capital and increase market efficiency by devising rules and procedures that increase the liquidity of traded assets. They should avoid laws and regulations that hurt the liquidity of the capital markets.
