The Sortino ratio is a risk-adjustment metric used to determine the additional return for each unit of downside risk. It is computed by first finding the difference between an investment’s average return rate and the risk-free rate. The result is then divided by the standard deviation of negative returns. Ideally, a high Sortino ratio is preferred, as it indicates that an investor will earn a higher return for each unit of downside risk.
The Sortino ratio measures the risk-adjusted return of an investment asset, portfolio, or strategy. It is a modification of the Sharpe ratio but penalizes only those returns falling below a user-specified target or required rate of return, while the Sharpe ratio penalizes both upside and downside volatility equally.
The Sortino ratio is a variation of the Sharpe ratio that differentiates harmful volatility from total overall volatility by using the asset’s standard deviation of negative portfolio returns—downside deviation—instead of the total standard deviation of portfolio returns. The Sortino ratio takes an asset or portfolio’s return and subtracts the risk-free rate, and then divides that amount by the asset’s downside deviation. The ratio was named after Frank A. Sortino.
Understanding the Sortino Ratio
If you’re looking to invest, you should not concentrate on only the rate of return. It would be better if you also considered the associated level of risk. Risk refers to the likelihood that an asset’s or security’s financial performance will differ from what is expected.
The downside risk is a potential loss from your investment. Conversely, a potential financial gain is known as an upside risk.
Unfortunately, many performance metrics fail to account for the variation in the risk of an investment. They merely calculate their rates of return. But not so with the Sortino ratio. The indicator examines changes in the risk-free rate; hence, enabling investors to make more informed decisions.
The Sortino ratio is an improvement of the Sharpe ratio, another metric that helps individuals gauge the performance of an investment when it has been adjusted for risk. What sets the Sortino ratio apart is that it acknowledges the difference between upside and downward risks. More specifically, it provides an accurate rate of return, given the likelihood of downside risk, while the Sharpe ratio treats both upside and downside risks equally.
How to Calculate the Sortino Ratio
The formula for calculating the Sortino ratio is:
Sortino Ratio = (Average Realized Return – Expected Rate of Return) / Downside Risk Deviation
The Difference Between the Sortino Ratio and the Sharpe Ratio
The Sortino ratio improves upon the Sharpe ratio by isolating downside or negative volatility from total volatility by dividing excess return by the downside deviation instead of the total standard deviation of a portfolio or asset.
The Sharpe ratio punishes the investment for good risk, which provides positive returns for investors. However, determining which ratio to use depends on whether the investor wants to focus on total or standard deviation, or just downside deviation.
Shortcomings of sharpe ratio are overcome by Sortino ratio as the former relies on standard deviation and uses mean return whereas latter lies on downside volatility. Generally speaking, some methods taking all periodic returns and if any returns exceed the minimum accepted value is considered to be zero and finally, the standard deviation is calculated. But as some returns considering as zero underestimates the volatility. One of the options is to ignore positive volatility itself and taking into account only the standard deviation of negative returns. As Sortino ratio is measuring the downside risk it captures the spirit. Like sharpe ratio, sortino ratio doesn’t guarantee future returns.
When to Use the Sortino Ratio
Compared to the Sharpe ratio, the Sortino ratio is a superior metric, as it only accounts for the downside variability of risks. Such an analysis makes sense, as it enables investors to assess downside risks, which is what they should worry about. Upward risks (i.e., when an investment generates an unexpected financial gain) aren’t really a cause for concern.
By comparison, the Sharpe ratio treats upside and downside risks in the same way. It means that even those investments that produce gains are penalized, which should not be the case.
Therefore, the Sortino ratio should be used to assess the performance of high volatility assets, such as shares. In comparison, the Sharpe ratio is more suitable for analyzing low volatility assets, such as bonds.
How an investor can measure the risk
Will, an investor choose a mutual fund based on returns only? Absolutely a big NO. So portfolio’s performance should be associated with volatility, a major factor resulting in risk-adjusted returns. Sharpe and Sortino ratios are the metrics used as performance measurement ratios.
The Sortino ratio is almost identical to the Sharpe ratio, but it differs in one way. The Sharpe ratio accounts for risk adjustments in investments with both positive and negative returns.
In contrast, the Sortino ratio examines risk-adjusted returns, but it only considers the downside risks. In such a way, the Sortino ratio is seen as a better indicator of risk-adjusted returns since it doesn’t consider upside risks, which aren’t a cause for concern to investors.