A client recently asked about the appropriateness of reporting volatility and tracking error, for one and three month time periods, based on daily values. In addition, whether the results should be annualized. He was curious about the “best practices” for reporting these values.
Volatility (presumably, standard deviation) requires at least 30 observations to have validity, and so a monthly statistic, based on the roughly 22 trading days in the month, wouldn’t quite make it, but it’s close; clearly the three-month period would. But, this begs a bigger question: the appropriateness of using daily values.
I would say that the “rule of thumb” is to only use monthly returns. And why is this? Because daily provide too much “noise.” Just consider the past week’s DJIA returns, where we’ve seen 100+ point movements up and down, allegedly in response to the economic crisis in Greece. Monthly returns smooth these gyrations out, into meaningful numbers. Quarterly would be arguably better, but to achieve the requisite 30 observations would require 7 1/2 years: a bit long for most folks.
As for annualizing the monthly or quarterly values, the “rule” is not to annualize returns for periods less than a year; I would think the same applies to risk stats. And, if your intent is to compare them to a monthly or quarterly return, why not have it represented in the same manner?
Disagree? Have different thoughts? Please chime in!