What is the relationship between liquidity and expected return?

Answer 1

Liquidity refers to how easy it is to market; that is, to buy and sell. Stocks are easy... very liquid investments easy to buy and sell. Bonds are also easy... you have plenty of buyers and sells. An example of an investment not very liquid could be a limited partnership... not many buyers or sellers, if any.
Expected return refers to the investment's potential... whether it is expected to earn 5%, 20%, or even more. It's purely guesswork on stocks... based on research and information, but surprises can be killers (recall Enron). The expected return on bonds is known if the bond is held to maturity... if sold before maturity, it also can go up or down in value... yet the interest paid will remain the same (unless, of course, there are problems with the issuer).
Therefore, if it's liquid, you can generally expect your investment to hold its own or increase in value... unless of course the company is losing money. But something illiquid, like a limited partnership, once it is purchased it is normally held by the buyer; but if he or she decides to sell, it's usually at a loss.... just not much of a market for that kind of thing.

Answer 2

I agree with both posters on the definition of liquidity but not its relationship to return.

Basically with something is not liquid it's returns will be magnified, up or down. Example: If a stock is not liquid and it is in demand, the bid price will drive the stock much higher, than had it been more liquid. But the inverse happens if people are trying to dump it. It will be driven down by the ask price dropping to find buyers. It is for this reason that penny stocks can be so much more dangerous than blue chips but offer more return potential. So, sometimes when they say 'you have to raise your risk, to gain potential return,' one way is to invest in vehicles with less liquidity.

Answer 3

Liquidity is used to describe how fast your assets can be turned into cash. Generally expected return will be greater for an item that is less liquid.