What Is the Sortino Ratio and How Does It Compare to Sharpe Ratio

The Sortino ratio is a measure of risk-adjusted return that's often overlooked in favor of its more popular cousin, the Sharpe ratio. It's a more nuanced metric that takes into account the impact of downside volatility on investment returns.

The Sortino ratio is particularly useful for investors who are sensitive to drawdowns, or losses. By focusing on the magnitude of losses rather than just volatility, the Sortino ratio provides a more accurate picture of an investment's risk profile.

One of the key differences between the Sortino and Sharpe ratios is how they handle downside risk. The Sharpe ratio, for example, penalizes investments for any kind of volatility, regardless of whether it's upside or downside.

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The Sortino ratio is a financial metric used to evaluate the risk-adjusted return of an investment, portfolio, or trading strategy. It's an enhancement to the Sharpe ratio, focusing on downside risk rather than overall volatility.

A higher Sortino ratio indicates a better risk-adjusted return, implying a higher return per unit of downside risk. This is because it takes into account the volatility of returns below the target, which is a key aspect of the Sortino ratio.

The Sortino ratio is calculated by dividing the excess return, or the return above the target, by the downside deviation.

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The Sortino ratio is a metric that evaluates the return on an investment or portfolio compared to the risk-free rate, similar to the Sharpe ratio. It's a modified variation of the Sharpe ratio, with adjustments to address its shortcomings.

To calculate the Sortino ratio, you need three inputs: Portfolio Return (rp), Risk-Free Rate (rf), and Downside Standard Deviation (σd). The portfolio return is the return on a portfolio, either on a historical basis or the expected returns according to the portfolio manager.

The risk-free rate is the return received on default-free securities, such as U.S. government bond issuances. The downside standard deviation is the standard deviation of solely the investment's or portfolio's negative returns, i.e. the downside deviation.

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The Sortino ratio formula is (R – Rf) / σd, where R is the portfolio return, Rf is the risk-free rate, and σd is the downside standard deviation.

To calculate the downside standard deviation, you need to identify the negative returns and square them. Then, add up the squared values and divide by the total number of months.

For example, if a portfolio has the following returns: 1%, 4%, 8%, 10%, 20%, 25%, 16%, 12%, 5%, 3%, -2%, and -4%, you would calculate the downside standard deviation as follows:

The downside standard deviation is 0.0167 or 1.67%.

The next step is to calculate the average excess return across the entire period. This is done by subtracting the risk-free rate from the portfolio return for each month and then averaging the results.

For example, if the risk-free rate is 2.5% and the portfolio return for each month is 1%, 4%, 8%, 10%, 20%, 25%, 16%, 12%, 5%, 3%, -2%, and -4%, the excess returns would be -1.5%, 1.5%, 5.5%, 7.5%, 17.5%, 22.5%, 13.5%, 9.5%, 2.5%, 0.5%, -4.5%, and -6.5%.

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The average excess return would be 3.5%.

Finally, divide the average excess return by the downside standard deviation to get the Sortino ratio. In this example, the Sortino ratio would be 3.5% / 0.0167 = 0.80.

The Sortino ratio is a useful tool for evaluating the risk-adjusted performance of an investment portfolio. It's a more nuanced metric than the Sharpe ratio, which takes into account only the upside and downside volatility.

Here's a summary of the Sortino ratio formula and calculation steps:

Note that the downside standard deviation is a critical component of the Sortino ratio calculation, and it's essential to accurately calculate it to get a reliable result.

The Sortino Ratio is a statistical tool that measures an investment's risk-adjusted return by focusing solely on downside volatility. It provides a more insightful interpretation of performance than the traditional Sharpe ratio.

By definition, the Sortino ratio is a measure of the excess return an investment earns relative to the minimum acceptable return. This excess return is per unit of downside risk for investors.

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Unlike the Sharpe ratio, which considers both upside and downside returns, the Sortino ratio considers only the downside returns. This makes it particularly useful for assessing investments with asymmetric risk profiles.

The Sortino ratio is a ranking device, so a portfolio's Sortino ratio should be compared to that of other portfolios rather than evaluated independently. In general, investors prefer higher Sortino ratios when comparing similarly managed portfolios.

A good Sortino ratio indicates higher returns per unit of downside risk, typically above 1.0, signaling efficient risk-adjusted performance. Most financial analysts prefer a score of two or above, but some may still accept a score of one and above.

The higher the Sortino ratio, the better, because a higher value indicates that the portfolio is more efficient and does not take on unnecessary risk without being rewarded with higher returns. When the Sortino ratio is very low or negative, the investment is not rewarded for taking on additional risk.

The Sortino ratio is essential to acknowledge the specific asset class of investment schemes, to evaluate an investment portfolio's performance more accurately. It is a useful way for analysts, portfolio managers, and retail investors to evaluate an investment's return per unit of bad risk over a specified period.

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The Sortino ratio measures the risk-adjusted return of an investment asset, portfolio, or strategy using only the downside risk. It excludes the upside volatility, which is beneficial to investors and should not be considered a risk.

A portfolio or strategy that produces strong upside moves and lower downside moves will have a better risk-adjusted score using the Sortino ratio than with the Sharpe ratio.

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The Sortino Ratio and Sharpe Ratio are two popular risk-adjusted measures of returns on investment. They're used to evaluate investment portfolios, but they have distinct differences.

The Sortino Ratio only accounts for downside risks, making it suitable for investment portfolios with high volatility. In contrast, the Sharpe Ratio considers both upside and downside volatility equally. This difference in approach can lead to varying results when comparing the two ratios.

Here's a comparison of the two ratios in a table:

Understanding the differences between these two ratios is crucial when evaluating investment portfolios.

The Sortino Ratio has its limitations, and one of the main issues is that it relies on downside deviation to measure risk, which can be influenced by the same shortcomings.

Since downside deviation requires enough "bad" risks or observations to be statistically noteworthy, the Sortino Ratio may not be effective if a portfolio has a lack of negative returns.

The Sharpe Ratio, on the other hand, uses standard deviation to measure risk, but this assumption of a normal distribution of equity returns is an oversimplification.

This is why variations of the Sharpe Ratio, such as the Sortino Ratio, have been developed to address this issue.

The Sortino Ratio is more practical for portfolios with high volatility, whereas the Sharpe Ratio is more applicable for portfolios with low volatility.

As a result, the Sortino Ratio is often used by returns-oriented investors who pursue higher returns through riskier strategies.

Here's an interesting read: Sortino vs Sharpe Ratio

The Sortino Ratio and Sharpe Ratio are two risk-adjusted measures of returns on investment, but they have some key differences.

The Sortino Ratio only accounts for downside risks, making it a better fit for investments with high volatility. It's a variation of the Sharpe Ratio, but with a focus on negative returns.

The Sharpe Ratio, on the other hand, considers both upside and downside volatility equally, which may not be suitable for all investors.

The main formula of the Sortino Ratio uses the target/required return instead of the risk-free rate of return in the numerator, but some people still use the risk-free rate to simplify the formula.

Here's a comparison of the two ratios in a table:

The Sortino Ratio is particularly useful for assessing investments with asymmetric risk profiles, focusing solely on downside risk by using the standard deviation of negative returns.

A ratio of one or higher is considered a risk-adjusted return of earnings, while a negative ratio suggests that a risk-free investment option may be a better choice.

Overall, understanding the differences between the Sortino Ratio and Sharpe Ratio can help investors and financial analysts make more informed decisions about their investments.