Capital gains, illiquidity, and stock returns

•This paper shows that the capital gains are positively related to the change in liquidity.•We find that the disposition effect is stronger for more illiquid stocks.•We verify that the interaction causes further price underreaction.•The Chinese stock markets help us to reach our objective.•This paper documents the complex relations among the three factors.

This paper investigates the tripartite association among capital gains, illiquidity, and stock market returns. We find that trading in capital gains improves stock liquidity. We also find that realized stock returns are negatively related to the joint term of illiquidity and capital gains, but positively correlated with capital gains. These results are largely robust when we distinguish stock liquidity from unexpected liquidity. Our findings are consistent with the disposition effect and have important implications for asset pricing models and for investing.