issues over the 1961-1980 period and defines liquidity in terms of bid-asked spreads as a percentage of overall share price. Market makers use spreads in quoting stocks to de- fine the difference between the price theyll bid to take stock off an investors hands and the price theyll offer to sell stock to any willing buyer. The bid price is always somewhat lower because of the risk to the broker of ty- ing up precious capital to hold stock in inventory until it can be resold. If a stock is relatively illiquid, which means theres not a ready flow of orders from customers clamoring to buy it, theres more of a chance the broker will lose money on the trade. To hedge this risk, market makers demand an even bigger discount to service potential sellers, and the spread will widen further. The study by Profs. Amihud and Mendelson shows that liquidity spreads-measured as a percentage dis- count from the stocks total price-ranged from less than 0.1%, for widely held International Business Machines Corp., to as much as 4% to 5%. The widest-spread group was dominated by smaller, low-priced stocks. The study found that, overall, the least-liquid stocks averaged an 8.5 percent-a-year higher return than the most-liquid stocks over the 20-year period. On average, a one percentage point increase in the spread was associ- ated with a 2.5% higher annual return for New York Stock Exchange stocks. The relationship held after re- sults were adjusted for size and other risk factors. An extension of the study of Big Board stocks done at The Wall Street Journals request produced similar find- ings. It shows that for the 1980-85 period, a one percent- age-point-wider spread was associated with an extra average annual gain of 2.4%. Meanwhile, the least-liquid stocks outperformed the most-liquid stocks by almost six percentage points a year.   Cost of Trading Since the cost of the spread is incurred each time the stock is traded, illiquid stocks can quickly become pro- hibitively expensive for investors who trade frequently. On the other hand, long-term investors neednt worry so much about spreads, since they can amortize them over a longer period. In terms of investment strategy, this suggests "that the small investor should tailor the types of stocks he or she buys to his expected holding period," Prof. Mendelson says. If the investor expects to sell within three months, he says, its better to pay up for the liquidity and get the lowest spread. If the investor plans to hold the stock for a year or more, it makes sense to aim at stocks with spreads of 3% or more to capture the extra return.   Source: Barbara Donnelly, The Wall Street Journal, April 28, 1987, p. 37. Reprinted by permission of The Wall Street Journal. 1987 Dow Jones & Company, Inc. All Rights Reserved Worldwide.     commonality across stocks in the variable cost of liquidity: quoted spreads, quoted depth, and effective spreads covary with the market and industrywide liquidity. Hence, liquidity risk is systematic and therefore difficult to diversify. We believe that liquidity will become an important part of standard valuation, and therefore present here a simplified