Liquidity Premium and Investment Horizons
Why stocks with thin trading volumes pay higher returns later
When fewer investors are buying or selling a stock, prices move more dramatically with each trade—a cost called the liquidity premium that investors demand as compensation. Researchers found they could predict which stocks would outperform by measuring daily order flow and how much prices swing around it, using 2020–2025 stock data. The finding suggests the premium isn't just about risk, but about how trading scarcity temporarily depresses prices and then corrects itself.
Portfolio managers and algorithmic traders can use order-flow measurements to identify underpriced stocks before the liquidity bounce occurs, potentially improving returns. Understanding that liquidity costs drive part of the return premium—rather than fundamental risk—helps investors distinguish between genuinely risky stocks and merely illiquid ones, leading to better capital allocation decisions.