Okay, so the decision has been made: effective January 2011, GIPS compliant firms must report a 36-month annualized standard deviation, on an annual basis (that is, for all years starting with 2011). Further clarity is in order.
First, is standard deviation risk? There is hesitation to call it that, because a lot of folks don’t consider it risk. But if it’s not risk, why show it? Granted, not everyone thinks of volatility as being a risk measure, but most firms report that they use standard deviation as a risk measure. If volatility isn’t risk, then is volatility such a valuable measure that we need to see it reported?
I think it’s a mistake NOT to call standard deviation risk: the fact that not everyone agrees shouldn’t be a reason not to. There is disagreement about much of the standards, but that doesn’t stop these items from being included. It’s even more confusing not to call standard deviation risk. Is someone going to be offended if we call it “risk”? I think not.
Is the Sharpe ratio a risk measure? Technically it’s a risk-adjusted return. And, what risk measure is used to adjust the return? Yes, you’re right: standard deviation. But if standard deviation isn’t risk, then I guess the Sharpe ratio can’t be a risk-adjusted measure. Who’s going to tell Bill?
Okay, and so HOW do we calculate standard deviation? First, use 36 months … not days, not quarters, not years: months! You will also be required to include the annualized return for each 36 month period. What if you don’t have 36 months’ of composite returns? Then don’t show this until you do (well, actually, you arguably can show a standard deviation for the period you have, but you’re not required to until you reach 36 months).
Do we divide by “n” or “n-1” (where “n” is the number of months (i.e., 36))? No decision has been made yet, though it appears from comments at this week’s conference that “n” might win out. We use “n” for the population and “n-1” for a sample; some might argue that it would be wrong to use “n,” while others would argue that it’s wrong to uses “n-1.” This is debatable and controversial, no doubt. And, no doubt more details will follow.