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Research Note

Andreas Steiner Consulting GmbH


February 2012

Annualized Volatility
Introduction
In this research note, we compare S&P 500 volatility figures calculated with the popular
square-root-n rule to volatility figures derived from time-aggregated daily returns and try to
reconcile the differences with popular time-series models featuring serial correlation in
returns or volatilities.
We show that the deviations from the square-root-n rule cannot be explained with serial
correlation in returns, rather with a GARCH model. We conclude that volatility figures
annualized with the square-root-n rule should not be interpreted as accurate estimates for
true annual volatility. The square-root-n rule is also not suitable to standardize volatility
figures for reporting purposes.

The Square-Root-N Rule


Volatility is financial market lingo for standard deviation of continuous returns1 and
generally used as a measure for return dispersion over time and a proxy for risk,
respectively for uncertainty.
If continuous returns are modeled as stochastic processes, volatility can be interpreted as
one particular characteristic of the process. Justified by the idea that price changes are
largely driven by unexpected changes in valuation factors, it is typically assumed that price
changes2 of financial assets are independent over time. In fact, this assumption is nothing
else than assuming that markets exhibit weak-form information efficiency.
It can be shown formally that this assumption leads to the so called square-root-n rule for
annualizing volatilities3

(1)

Annualized Calculated n

with Calculated as the standard deviation measured from a time series of continuous returns
and n being the data frequency of this time series expressed in periods per annum. For
example, if we are calculating volatility of 6% from a monthly return time series, the squareroot-n rule tells us that the annualized volatility is
(2)

Annualized 6% 12 20.78%

2011, Andreas Steiner Consulting GmbH. All rights reserved.

Electronic copy available at: http://ssrn.com/abstract=2007620

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The assumptions underlying the rule imply that it should not make a difference whether we
calculate annual volatility from annual, monthly, daily etc. returns. Therefore

Annualized Calculated, Daily 250 Calculated, Monthly 12 Calculated,Quarterly 4

(3)

More generally, the square-root-n rule can be used to convert volatilities calculated from
returns with a certain frequency to volatility figures for returns over a longer time period. For
example, quarterly volatility can be derived from monthly volatilities as follows

Quarterly Calculated, Monthly 3

(4)

Ironically, the square-root-n rule is used every day by thousands of active investment
managers in ex ante as well ex post portfolio analytics, i.e. investment managers which can
only create value-added for their clients if markets are at least informationally inefficient of
the weak form.

Annualized S&P500 Volatilities


In order to assess the validity of the square-root-n rule, we have analyzed a data set
consisting of S&P 500 daily continuous price returns from January 5, 1987 to November 20,
2011 (data source: Yahoo Finance).
We calculate annualized S&P500 volatility figures with two methods

Square-Root-N rule: Using daily volatility as a starting point, we calculate volatility


figures for various longer time periods up to one year (250 trading days)

Time-Aggregated Returns: Instead of converting volatilities, we convert the return


data. For example, weekly continuous returns can be calculated from daily returns
by simply adding five daily observations. The weekly return series generated this
way can then be used to calculate weekly volatility.

An alternative way to time-aggregated returns would be to resample/bootstrap from the


daily return data set. Nave resampling procedures destroy any dependence of returns or
volatilities over time. More sophisticated resampling procedures trying to preserve
dependence patterns exist, but introduce additional assumptions into the analysis. As
intertemporal dependence patterns are at the core of the issues discussed here, we prefer
to calculate volatilities from historical time-aggregated returns as described above.
The results from the above calculations4 can be summarized graphically

2011, Andreas Steiner Consulting GmbH. All rights reserved.

Electronic copy available at: http://ssrn.com/abstract=2007620

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25.00%
22.50%
Time-Aggregated Returns

20.00%
Square-Root-N Rule

Annualized Volatility

17.50%
15.00%
12.50%
10.00%
7.50%
5.00%
2.50%
0.00%
0

50

100
150
200
Time Period [Expressed in Number of Periods p.a.]

250

As we can see, volatilities calculated with the square-root-n rule generally do not coincide
with true historical volatilities calculated from time-aggregated returns. In this particular
case, the square-root-n rule seems to overestimate volatility on average by approximately
15%, in some cases by almost 25%.
The above result that returns are not independent is not really new, but has been reported
in numerous empirical studies. The more interesting question is: which kind of
independence over time causes the square-root-n to fail? This question is of practical
relevance, since certain dependence structures allow to filter the original data such that
the square-root-n rule can still be used.

Dependence in Returns and Volatilities


The simplest way to model dependence of returns over time is to assume that returns are
linearly autocorrelated5. Various explanations exist for autocorrelation in returns. For
example, it is rather typical to find autocorrelation in returns on markets with pricing issues
(e.g. fixed income, private equity, real estate).
Autocorrelation patterns in returns can be detected in a chart plotting autocorrelation
coefficients for returns at various lags. For our S&P500 data

2011, Andreas Steiner Consulting GmbH. All rights reserved.

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6.00%

Autocorrelation Coefficient

4.00%

2.00%

0.00%

-2.00%

-4.00%

-6.00%

1
8
15
22
29
36
43
50
57
64
71
78
85
92
99
106
113
120
127
134
141
148
155
162
169
176
183
190
197
204
211
218
225
232
239
246

-8.00%
Lag

The red dotted lines define a confidence band; autocorrelation coefficients outside the band
can be considered statistically significant.
As we can see, autocorrelation coefficients for daily S&P500 returns are generally small,
and not statistically significant most of the time. This picture is rather typical for a rather
efficient market; price changes seem to be unpredictable, unsuitable for simple shorts-term
momentum or contrarian trading strategies.
One popular method to remove autocorrelations is the Blundell-Ward filter. This filter is
capable of removing first-order autocorrelations (i.e. autocorrelations calculated at lag one).
If we apply the Blundell-Ward filter to our S&P500 return series and then recalculate
volatilities, we get

25.00%
22.50%
Time-Aggregated Returns
20.00%
Square-Root-N Rule

Annualized Volatility

17.50%

15.00%
12.50%
10.00%
7.50%

5.00%
2.50%
0.00%
0

50

100
150
200
Time Period [Expressed in Number of Periods p.a.]

2011, Andreas Steiner Consulting GmbH. All rights reserved.

250

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As we can see, the Blundell-Ward filter removing first-order autocorrelations does not
improve the performance of the square-root-n rule significantly. The square-root-n rule still
systematically overestimates true volatilities.
Interestingly, autocorrelations for the squared returns of the same return time series
look very different

35.00%

30.00%

Autocorrelation Coefficients

25.00%

20.00%

15.00%

10.00%

5.00%

0.00%

1
8
15
22
29
36
43
50
57
64
71
78
85
92
99
106
113
120
127
134
141
148
155
162
169
176
183
190
197
204
211
218
225
232
239
246

-5.00%
Lags

Autocorrelations in squared returns are clearly much larger (as high as 30%), statistically
significant and exhibit a decaying pattern with lag size. This pattern is typical for first-order
autoregressive processes. How do we interpret autocorrelations in squared returns
economically? This can be seen from the definition of standard deviation if we assume that
the arithmetic mean is so small that it can be neglected

(5)

N
N
1
1
2
ri r
ri 2
r 0 N 1
N 1 i 1
i 1

If the average return is small (and average daily returns are small indeed), then the
squared return can be interpreted as a contribution to volatility, respectively a volatility
innovation. Autocorrelations in squared returns can, therefore, be interpreted as
autocorrelation in volatility.
The most popular model exhibiting autocorrelation in volatility is GARCH(1,1), a specific
parameterization of a more general class of generalized autoregressive conditional
heteroscedastic models. Estimating the GARCH(1,1) allows one to compute short-term
volatilities, which are assumed to exhibit first-order autocorrelation.

2011, Andreas Steiner Consulting GmbH. All rights reserved.

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8.00%

7.00%

6.00%

Daily Volatilites

Long-Term GARCH(1,1) Volatility


5.00%
Short-Term GARCH(1,1) Volatilities
4.00%

3.00%

2.00%

1.00%

05.01.10

05.01.11

05.01.08

05.01.09

05.01.06

05.01.07

05.01.04

05.01.05

05.01.02

05.01.03

05.01.01

05.01.99

05.01.00

05.01.97

05.01.98

05.01.95

05.01.96

05.01.93

05.01.94

05.01.91

05.01.92

05.01.90

05.01.88

05.01.89

05.01.87

0.00%

In our context here, we use the short-term GARCH(1,1) volatilites to adjust returns for
intertemporal dependence arising through volatilities. This is achieved by standardizing the
returns with the current short-term GARCH(1,1) volatility. If the GARCH(1,1) model holds,
then the standardized returns should exhibit no autocorrelation. We verify this by
recalculating the autocorrelation chart with the squared standardized returns

7.00%

6.00%

Autocorrelation Coefficients

5.00%
4.00%
3.00%
2.00%
1.00%
0.00%
-1.00%
-2.00%

1
7
13
19
25
31
37
43
49
55
61
67
73
79
85
91
97
103
109
115
121
127
133
139
145
151
157
163
169
175
181
187
193
199
205
211
217
223
229
235
241
247

-3.00%
Lags

2011, Andreas Steiner Consulting GmbH. All rights reserved.

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It looks like the GARCH(1,1) model explains autocorrelation in squared returns rather well.
In the chart below, we applied the square-root-n rule and volatility calculations based on the
time-aggregated returns to the GARCH(1,1)-standardized return

20.00

18.00
16.00

Annualized Volatility

14.00
12.00

10.00
8.00
6.00
4.00
2.00
0

50

100

150

200

250

Time Period [Expressed in Number of Periods p.a.]

The GARCH(1,1) model nicely removes the systematic bias: the differences between the
volatilities calculated from time-aggregated returns and with the square-root-n rule are not
only smaller, but their signs seem to vary randomly.
Unfortunately, the volatility figures calculated from GARCH(1,1) standardized returns no
longer have an economic meaning. This is not a surprise, because GARCH(1,1) not only
feature first-order autocorrelation of volatilities, but also mean reversion. For example, in
turbulent times with high realized volatilities, volatilities have a tendency to revert back to a
lower long-term value. Annualizing with a square-root-n rule becomes meaningless, as we
would either need to predict future volatility innovations or work with expected volatility
innovations (which are zero by definition). Annualizing in a GARCH world is really
calculating forward volatilities, given current volatility levels and some GARCH parameters.6

Conclusions
Unlike returns, true volatility is a characteristic of a financial asset or portfolio which
cannot be measured directly, but always has to be estimated7. This statement applies to ex
ante as well as ex post analysis. While ex post return measurement is mainly an
accounting exercise, measuring ex post return volatility is about statistical inference,
requiring a rather different skill set from the person executing the calculations.
The square-root-n rule is a formula based on very specific assumptions. Unfortunately, the
rule is used by many practitioners without questioning whether data characteristics justify
the underlying assumptions. Additionally, many systems used by practitioners do not
2011, Andreas Steiner Consulting GmbH. All rights reserved.

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generate indicators which would allow users to assess the quality of the annualized
volatility figures calculated.
We do not recommend annualization of volatility figures for reporting purposes, as the
operation is likely to introduce systematic biases when comparing results for different return
time series. We recommend calculating annualized volatility from time-aggregated (i.e.
annualized) returns instead. If the square-root-n rule has to be used, for example, due to
lack of access to the return series, we recommend to disclose additional information like
the data frequency at which the original volatility calculations were performed or statistical
indicators for autocorrelation in returns.

See our research note on how to calculate discrete volatility.

And therefore returns, which are nothing else than relative price changes.

There exist other simple scaling rules if we make stronger assumptions about the stochastic
process generating returns. For example, if we assume that returns follow a so-called stable
distributions. But as financial returns generally exhibit finite variances, stable distributions are
generally not relevant for financial time series.
4

All calculations in this research note were performed using our Advanced Portfolio Analytics
Excel Add-In, see www.andreassteiner.net/apalib for more information.
5

Some authors use the expression serial correlation instead of autocorrelation.

The formulas to calculate expected forward volatiles can be found in the GARCH literature.

Alternatively, volatility can be inferred from markets: ex ante volatility is traded on rather liquid
markets (e.g. VIX). Ex post volatility is traded on (rather illiquid) OTC markets for certain
derivative instruments (e.g. variance swaps).

2011, Andreas Steiner Consulting GmbH. All rights reserved.

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