Why liquidity is the hidden tax on every small cap return…

Every investor knows what brokerage costs. It’s on the contract note, in rand and cents, impossible to miss.

What almost no retail investor calculates, and what can dwarf that brokerage fee many times over, is liquidity cost. The price you actually pay to get into a small cap, and the price you actually receive to get out of one, when very few shares change hands on any given day.

This is not a theoretical risk. On the JSE, where small-cap trading volumes can be a tiny fraction of large-cap volumes, liquidity cost is one of the most consistently underestimated expenses in a retail portfolio.

It doesn’t show up as a line item. It shows up as a worse entry price, a worse exit price, and – in the worst cases – an inability to exit a position at any reasonable price when you actually need to.

What liquidity cost actually is

Liquidity cost has two components and understanding both is the difference between an investor who manages this risk and one who discovers it the hard way.

#1: The bid-ask spread is the gap between what a buyer is willing to pay and what a seller is willing to accept, at any given moment.
For a liquid large cap, that spread might be a few cents on a R100 share – a rounding error. For a thinly traded small cap, the spread can be 3%, 5%, even 10% of the share price. Every time you buy, you’re paying the ask. Every time you sell, you’re receiving the bid. That gap is a cost you pay on day one, before the share has moved a single cent in your favour.

#2: Price impact is what happens when your own order is large enough, relative to the available volume, to move the price against you.
If a small cap trades R50,000 worth of shares on an average day and you try to buy R200,000 worth in a single session, you aren’t buying at the quoted price, you’re buying at a steadily rising price as you consume the available sell orders. The same happens in reverse when you sell. Price impact is invisible until you try to trade in size, and then it becomes very visible very quickly.

The number that actually matters: days to liquidate

Beyond the spread, the single most useful liquidity metric for a small-cap investor is simple: how many trading days would it take to exit your position without materially moving the price?

Days to liquidate = Position size ÷ (Average daily traded value × 0.2)

The 20% figure is a conservative industry rule of thumb. The idea that consuming more than roughly a fifth of a stock’s average daily volume in a single session starts to move the price meaningfully against you.

A R500,000 position in a stock that trades R100,000 a day, by this formula, would take 25 trading days (five weeks) to exit cleanly. If that capital is needed for an emergency, a margin call, or simply a change of conviction, the investor isn’t free to leave. They’re trapped by their own position size relative to the market’s capacity to absorb it.

Why this matters more on the JSE than almost anywhere else

The JSE has lost over 500 listed companies since 1989, and the resulting concentration means institutional capital increasingly clusters in a shrinking pool of large, liquid names – leaving the remaining small caps with even thinner trading volumes than their fundamentals alone would suggest.

Fewer companies competing for institutional attention doesn’t mean more liquidity per company. In practice, it has meant the opposite: retail investors are often the marginal buyer and seller in JSE small caps, in a way that’s far less true in deeper markets like the US or UK.

That has a specific implication. Liquidity risk on the JSE isn’t just a stock-specific issue. It’s a structural one that affects the entire small-cap universe, and it tends to get worse, not better, in exactly the moments an investor most wants to sell: market-wide sell-offs, when everyone is trying to exit illiquid positions simultaneously and buyers disappear.

Four practical rules for managing liquidity risk

1) Check average daily traded value before you check the share price
Most investors research a small cap’s fundamentals thoroughly and check the liquidity as an afterthought, if at all. Reverse the order. Before falling in love with the valuation case, look at 30-day and 90-day average daily traded value. If you can’t find a comfortable position size that represents a small fraction of that volume, the valuation case may be academic – you may not be able to execute it at a sensible cost.

2) Size your position to the stock’s liquidity, not just to your conviction
A common mistake is sizing a position purely on conviction: “I’m confident, so I’ll buy a meaningful amount.”
On an illiquid small cap, conviction should be capped by tradability. A reasonable rule: never let a single small-cap position exceed roughly 10–15% of that stock’s average daily traded value, ensuring you could realistically exit within a handful of trading sessions if your thesis changes.

3) Use limit orders, never market orders, on thin stocks
A market order on an illiquid small cap is an open invitation to pay the worst available price. Limit orders let you set the maximum price you’ll pay or the minimum you’ll accept – protecting you from the worst of the spread, even if it means your order takes longer to fill, or doesn’t fill at all in a single session.

4) Build and exit positions in tranches, not single trades
Spreading a purchase or sale across several sessions – rather than executing the full size in one trade – reduces price impact significantly. It costs a little more in time and attention. It typically costs far less in execution price, particularly on stocks where your order size is meaningful relative to daily volume.