Realized, expected and unexpected returns in asset pricing tests

We test linear asset pricing models of stock returns while accounting for the fact that realized returns may deviate from expected returns. To control for such information surprises, we decompose realized returns into an ex ante expected component—estimated using the implied cost of capital approach—and an unexpected component that reflects cash flow and discount rate news. Applying this framework to various multi-factor models reveals that previously significant pricing errors can become insignificant once realized returns are adjusted for these unexpected components—and vice versa. Alternative methods, such as using predictive regressions to estimate expected returns, yield similar findings. These results suggest that pricing errors based solely on realized returns may falsely lead to the rejection of an asset pricing model.