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Why Using The Square Root When Annualizing Volatility 1722343884

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Why Using The Square Root When Annualizing Volatility 1722343884

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choufani50yt
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Portfolio Theory Basics

Understanding Annualizing Volatility

Alexandre Landi

IBM, Skema Business School

July 30, 2024

Alexandre Landi (IBM, Skema) Portfolio Theory Basics July 30, 2024 1/7
Introduction to Annualizing Volatility

Annualizing Volatility
Process of scaling short-term volatility to an annual basis
Essential for comparing different timeframes
Useful for investments with different reporting intervals

Annualizing volatility is a process of scaling the calculated standard deviation of returns to an annual basis, regardless of the
original period of the returns. This standardization allows for a consistent comparison across investments with different time
frames.

Alexandre Landi (IBM, Skema) Portfolio Theory Basics July 30, 2024 2/7
Scaling Process

Formula for Annualizing Volatility


√
Annualized Volatility = Volatility × Number of Periods in a Year

Volatility: Standard deviation of returns over the original time period


Number of Periods in a Year: 252 for daily, 52 for weekly, 12 for
monthly

To annualize volatility, we multiply the standard deviation (volatility) of the returns by the square root of the number of periods
in a year.

Alexandre Landi (IBM, Skema) Portfolio Theory Basics July 30, 2024 3/7
Why Use the Square Root?

Explanation of the Square Root


Volatility is the square root of variance
Annualized variance = Variance × Number of Periods in a Year
√
Annualized volatility = Annualized Variance

The reason we multiply by the square root of the number of periods in a year when annualizing volatility is because we are
effectively taking the square root of the annualized variance. Volatility is the standard deviation, which is the square root of
variance.

Alexandre Landi (IBM, Skema) Portfolio Theory Basics July 30, 2024 4/7
Mathematical Justification

Mathematical Justification
Annualized Variance = Variance × Number of Periods in a Year
√ √
Annualized Variance = Variance × Number of Periods in a Year
√ √ √
Annualized Variance = Variance × Number of Periods in a Year
√
Annualized Volatility = Volatility × Number of Periods in a Year

The annualized variance is given by: Annualized Variance = Variance × Number of Periods in a Year. To convert this
annualized variance back to volatility, we take its square root.

Alexandre Landi (IBM, Skema) Portfolio Theory Basics July 30, 2024 5/7
Examples

Examples of Annualizing Volatility


√
Daily: Annualized Volatility = Volatility × 252
√
Weekly: Annualized Volatility = Volatility × 52
√
Monthly: Annualized Volatility = Volatility × 12

Here are examples for different periods: Daily returns have 252 trading days in a year, weekly returns have about 52 weeks, and
monthly returns have 12 months.

Alexandre Landi (IBM, Skema) Portfolio Theory Basics July 30, 2024 6/7
Summary

Importance of Annualizing Volatility


Allows for consistent risk comparison across different timeframes
Essential for portfolio management and risk assessment

This scaling allows us to compare the risk (volatility) of different investments on an equal footing, regardless of the time frame
of their returns.

Alexandre Landi (IBM, Skema) Portfolio Theory Basics July 30, 2024 7/7

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