Investor Sentiment and the Time Variation of the Illiquidity Premium

This paper examines the return premium associated with illiquidity through time. Prior research has documented that investors command a return premium for holding the most illiquid stocks. The idea behind the return premium is that investors demand higher returns as compensation for the risk of not being able to liquidate their position in a timely manner (see Amihud and Mendelson (1986)). We find that the illiquidity premium has substantial variation across time. For instance, during the 25 years examined, the illiquidity premium is only significant in 11 of those years. In fact, the standard deviation of the illiquidity return premium is greater than the average return premium in some specifications. In additional tests, we find that during periods of low investor sentiment, the illiquidity premium is the highest, suggesting that sentiment might contribute to the observed time variation in the premium.