The Fundamentals of Investing 11

its limitations, you can make a decision as to whether or not to use it

or to what degree.
And that is exactly what I do. I always look at beta, then I look at all
the other important numbers, ratios, alpha (defined later), and numer-
ous articles with specific reference to economics before I make an invest-
ment decision.
Beta represents the volatility of a stock or fund as compared with
the market in total. The market, as measured by the S&P 500, has a beta
of 1.0. A beta higher than 1.0 represents more volatility, while a beta less
than 1.0 indicates less volatility. The following is the formula for deter-
mining beta:

( (N) (Sum of XY) )
( (Sum of X) (Sum of Y) )

Where N  the number of observations
X  rate of return for the S&P 500 Index
Y  Rate of return for stock or fund.
Now let’s look at this realistically so it actually makes sense. The
simpler method to “accurately” determine beta is to merely look at
the movement of the stock or fund versus an index over a period of
time, say one year. The time period is significant. A short period of time,
say three or six months, is statistically insignificant and not going to
provide valuable numbers. A long period of time, say most periods over
five years, simply incorporates too many variables (called noise) and
may also not be worthwhile. So the betas you review should be based
on one-year, three-year, and five-year periods.
The S&P 500 is the market index normally used for most studies as
a reflection of everything that is happening. The S&P 500 actually does
not include the entire market—it includes about 80 percent of total
market capitalization —but it is generally the acceptable reference for
most studies. The whole key to the exercise is to recognize that what-
ever the market and S&P 500 Index does, it does so by a factor of 1.0.
Therefore, no matter what it does—be it a positive return of 3 per-