ONE OF THE FUNDAMENTAL ISSUES in finance is what the factors are that affect expected return on assets, the sensitivity of expected return to those factors, and the reward for bearing this sensitivity.There is a long history of testing in this area, and it is clearly one of the most investigated areas in finance.Almost all of the testing I am aware of involves using realized returns as a proxy for expected returns.The use of average realized returns as a proxy for expected returns relies on a belief that information surprises tend to cancel out over the period of a study and realized returns are therefore an unbiased estimate of expected returns.However, I believe that there is ample evidence that this belief is misplaced.There are periods longer than 10 years during which stock market realized returns are on average less than the risk-free rate ~1973 to 1984!.There are periods longer than 50 years in which risky long-term bonds on average underperform the risk free rate ~1927 to 1981!. 1 Having a risky asset with an expected return above the riskless rate is an extremely weak condition for realized returns to be an appropriate proxy for expected returns, and 11 and 50 years is an awfully long time for such a weak condition not to be satisfied.In the recent past, the United States has had stock market returns of higher than 30 percent per year while Asian markets have had negative returns.Does anyone honestly believe that this is because this was the riskiest period in history for the United States and the safest for Asia?Furthermore, there is a large body of evidence we find anomalous.This includes the effect of inf lation on asset pricing and the failure of the generalized expectation theory to explain term premiums.Changing risk premiums and conditional asset pricing theories may be a way of "explaining" some of the anomalous results; however, this does not explain returns on risky assets that are less than the riskless rate for the long periods when it has occurred.It seems to me that the more logical explanation for these anomalous results is that realized returns are a very poor measure of expected returns and that information surprises highly inf luence a number of factors in our

Edwin J. Elton, An Operational Approach to Risk-Screening: Discussion, The Journal of Finance, Vol. 28, No. 2, Papers and Proceedings of the Thirty-First Annual Meeting of the American Finance Association Toronto, Canada, December 28-30, 1972 (May, 1973), pp. 368-369

Edwin J. Elton, Test of a Stock Valuation Model: Discussion, The Journal of Finance, Vol. 25, No. 2, Papers and Proceedings of the Twenty-Eighth Annual Meeting of the American Finance Association New York, N.Y. December, 28-30, 1969 (May, 1970), pp. 500-502

Daily data from interdealer government bond brokers are examined for tax and liquidity effects. We use two approaches to create cash flow matching portfolios of similar securities and look for pricing discrepancies associated with liquidity or tax effects. We also look for the presence of tax and liquidity effects by including a liquidity term when fitting a cubic spline to the after-tax yield curve. We find evidence of tax timing options and liquidity effects. However, the effects are much smaller than previously reported and the effects of liquidity are primarily due to high volume bonds with long maturities.

Edwin J. Elton, Martin J. Gruber; Reflections on the Origins of the European Finance Association, European Finance Review, Volume 3, Issue 1, 1 January 199