Liquidity the most influencial factor | stockbee


Liquidity the most influencial factor

CXO Advisory Group blog today has a post about a recent research paper which has looked at various factors affecting stock returns.

March 2007 paper entitled "Too Many Factors! Do We Need Them All?", Soosung Hwang and Chensheng Lu seek to identify the minimum number of economically fundamental factors needed to explain why different stocks generate different returns.

Now if you go through the paper and read it , it has tested 16 factors considered to affect equity returns and concludes that liquidity is the most important factor followed by momentum. The study conclusion is only three factors are necessary and sufficient to explain difference in returns among individual stocks, with liquidity the most influential.

Too Many Factors! Do We Need Them All?

Cass Business School - Faculty of Finance
City University London - Sir John Cass Business School March 2007

We investigate more than a dozen of factors formed on firm characteristics and risk measures that have been claimed to be able to explain cross-sectional asset returns in the literature. In accordance to Fama and French (1993, 1996a), we use these factors in asset pricing, and show that the market portfolio, liquidity and coskewness explain the stock returns as well as the famous Fama-French three factors with momentum. In particular, in most sample periods tested, individual stocks' alphas are insignificant with only two factors, market portfolio and liquidity; in addition, many factors are redundant in asset pricing and are likely to come from data-mining.


F. said...

Thanks for the info. I have always been a huge liquidity fan. It is my number 1 indicator in any market analysis that I do. Number 2 is volatility.

Pradeep Bonde said...

Yes on a short time frames extreme liquidity often leads to reversal, that is why countetrend trades work extremely well for day trading.

F. said...

Liquidity is awesome to watch. Sometimes you will see programs buy the index futures in attempt to "buy the dip" only to see all these computers capitulate all at once and volume goes through the roof in milliseconds.

Liquidity is also helpful in forming swing/position ideas as your past two articles have shown.

James said...

I'm trying to read the paper and, well, I see that there are maaany things that I don't know.

Do you know what is the "coskewness" or the "stocks’ alphas" ?

James said...

What do they mean by "cross-sectional asset returns" ? It's the "cross-sectional" that I don't grasp.

Pradeep Bonde said...

To understand most academic research, you need heavy duty understanding of statistics.
Cross sectional means at a point in time. Coskew, kurtosis and many other terms used in that articles relate to skewness. Skewness is basically asymmetry in a frequency distribution.
Coskewness is the contribution of the security to the skewness of the well diversified portfolio.
That is my understanding of it. The statisticians and mathematicians will be better able to explain it.