Investments, tenth edition

  Liquidity and the Equity Premium Puzzle 

 We’ve seen that liquidity risk is potentially important in explaining the cross section of 

stock returns. The illiquidity premium may be on the same order of magnitude as the mar-

ket risk premium. Therefore, the common practice of treating the average excess return on 

a market index as an estimate of a risk premium per se is almost certainly too simplistic. 

Part of that average excess return is almost certainly compensation for  liquidity  risk rather 

than just the (systematic)  volatility  of returns. If this is recognized, the equity premium 

puzzle may be less of a puzzle than it first appears.