You have recently purchased stock in Topical Inc. which has returned between 7% and 9% over the last three years. Your friend, Bob, has criticized your purchase and insists that you should have invested in Combs Inc., as he did, because it’s been returning between 10% and 12% in the last three years. Bob knows nothing about financial theory. Topical’s beta is 0.7 and Comb’s is 1.2. Treasury bills are currently yielding the risk free rate of 4.2%, while the stock market is returning an average rate of 9.4%.
a. What return should you expect from Topical? What return should Bob expect from Combs?
b. Write a few words explaining to Bob why these expected returns aren’t the whole story.