Sortino Ratio vs Sharpe Ratio: A Comprehensive Comparison

The Sortino Ratio and Sharpe Ratio are two popular metrics used to evaluate investment performance, but they have distinct differences. The Sortino Ratio is more sensitive to downside risk, making it a better choice for investors who want to minimize losses.

The Sharpe Ratio, on the other hand, is more focused on overall risk, including both upside and downside risk. It's a more traditional metric that has been widely used in the industry.

The Sortino Ratio is particularly useful for investors who want to minimize drawdowns, or periods of significant losses. This is because it only considers negative returns, making it a more nuanced measure of risk.

The Sortino Ratio is a risk-adjusted performance metric that measures an investment's excess return over a certain level, such as the risk-free rate. It's a useful tool for investors seeking to understand the trade-off between risk and return.

The Sortino Ratio is calculated by dividing the excess return of an investment by the standard deviation of its negative returns. This helps investors identify investments that are less volatile and offer higher returns.

This metric is particularly useful for investors who are risk-averse and want to minimize losses. By focusing on negative returns, the Sortino Ratio provides a more accurate picture of an investment's risk profile.

In contrast to the Sharpe Ratio, which uses the overall standard deviation of returns, the Sortino Ratio is more sensitive to extreme losses. This makes it a better choice for investors who want to avoid large drawdowns.

The Sortino Ratio can be used in conjunction with the Sharpe Ratio to get a more comprehensive view of an investment's performance. By comparing the two ratios, investors can identify investments that offer a better balance of risk and return.

The Sortino Ratio is a risk-adjusted return measure that helps investors assess the performance of their portfolio. It's a key tool for evaluating the risk-adjusted return of an investment portfolio and its performance.

The Sortino Ratio focuses on the downside risk, which is a more important aspect of risk for investors who are risk-averse. Higher risk investments typically yield higher returns, but the Sortino Ratio takes into account the risk taken by the fund to generate returns.

The Sortino Ratio is a better way to assess a portfolio, especially for investors who prioritize downside protection. It's a more nuanced measure than the simple return, which ignores the risk taken by the fund to generate returns.

The Sortino Ratio is a useful tool for investors who want to evaluate the risk-adjusted return of their portfolio and make informed decisions about their investments.

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, where the adjustments applied in the calculation are intended to address its shortcomings.

To calculate the Sortino ratio, you'll 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.

Here's a step-by-step example of calculating the Sortino ratio:

1. Calculate the excess returns by subtracting the risk-free rate from the portfolio return.

2. Identify the negative returns and calculate their squares.

3. Add up the squared negative returns and divide by the total number of months to get the downside deviation.

4. Divide the average excess returns by the downside deviation to get the Sortino ratio.

In the example provided, the portfolio had a risk-free rate of 2.5%, and the downside deviation was 4.4%. The average excess returns were 3.5%, resulting in a Sortino ratio of 0.80.

The Sortino ratio can be effectively applied to retail investments because there is more concern for the downside risk. Unlike the Sharpe ratio, the Sortino ratio does not consider the total volatility of the investment, only the downside deviation.

Here's a summary of the Sortino ratio formula:

rp = Portfolio Return

rf = Risk-Free Rate

σd = Downside Deviation

While the portfolio return could be calculated on a forward basis, most investors and academics place more weight on actual, historical results.

A higher Sortino ratio result is better, and it means that the investment is earning more return per unit of bad risk that it takes on.

To calculate the Sortino ratio, you need to know the investment's annualized return, downside deviation, and the risk-free rate. For example, Mutual Fund X has an annualized return of 12% and a downside deviation of 10%, while Mutual Fund Z has an annualized return of 10% and a downside deviation of 7%.

The Sortino ratio for Mutual Fund X is 0.95, while the Sortino ratio for Mutual Fund Z is 1.07. Even though Mutual Fund X is returning 2% more on an annualized basis, it is not earning that return as efficiently as Mutual Fund Z.

Investors can use the expected return in calculations instead of the risk-free rate, but they should be consistent in terms of the type of return.

The Sortino Ratio and Sharpe Ratio are two popular metrics used to evaluate risk-adjusted returns. The Sharpe Ratio, named after Nobel laureate William F. Sharpe, measures the excess return of an investment per unit of total risk, or volatility.

The Sortino Ratio, developed by Frank A. Sortino, focuses specifically on downside risk, considering only the volatility associated with negative returns. It penalizes portfolios more for negative returns than for positive returns, making it suitable for risk-averse investors who prioritize capital preservation.

The Sharpe Ratio assumes that both upside and downside volatility contribute equally to risk, whereas the Sortino Ratio acknowledges that investors perceive upside and downside volatility differently. This makes the Sortino Ratio a better choice for evaluating portfolios with asymmetric risk profiles.

A higher Sortino Ratio indicates better risk-adjusted performance, specifically in terms of downside risk. It's particularly useful for assessing portfolios with significant losses, such as hedge funds or concentrated stock portfolios.

The Sortino Ratio is calculated as the excess return divided by the downside volatility, whereas the Sharpe Ratio is calculated as the excess return divided by the portfolio volatility. This difference in calculation makes the Sortino Ratio more sensitive to extreme negative returns.

The Sortino Ratio would favor a portfolio with lower downside volatility, even if it has lower overall returns. For example, Portfolio B, with lower returns but lower downside volatility, would be preferred over Portfolio A, which has higher returns but higher downside volatility.

In summary, the Sortino Ratio and Sharpe Ratio provide valuable insights into risk-adjusted returns, but they serve different purposes. The Sortino Ratio is ideal for risk-averse investors who prioritize capital preservation, while the Sharpe Ratio is more suitable for investors who can tolerate some risk in pursuit of higher returns.

In 1959, Harry Markowitz mentioned that semi-variance is a more plausible measure of risk than his mean-variance theory. This idea laid the groundwork for a future innovation in risk metrics.

The concept of semi-variance was revisited two decades later by Dr. Frank Sortino, a finance professor at San Francisco State University. He emerged with a new risk metric that would change the game.

In 1980, Sortino published the Sortino Ratio, which only penalizes deviations that fall under the target rate of return. This approach is different from the Sharpe Ratio, which considers all deviations.

The Sortino Ratio formula is straightforward, but it's often calculated incorrectly. To avoid this, let's go through an example to demonstrate how to calculate the ratio.

The Sortino Ratio has its strengths, but it's not the only game in town. Other risk metrics, such as the Sharpe Ratio, can provide valuable insights into investment performance. The Sharpe Ratio, for example, considers both upside and downside volatility, whereas the Sortino Ratio focuses solely on downside risk.

The Treynor Ratio is another risk metric that's worth mentioning. It's similar to the Sharpe Ratio but uses beta (systematic risk) instead of total volatility. This makes it particularly useful for evaluating portfolios with exposure to market risk.

The Information Ratio measures an active manager's ability to generate excess returns relative to a benchmark. It's expressed as the active return divided by the tracking error. This metric is useful for evaluating active managers, but it doesn't specifically address downside risk.

The Omega Ratio takes into account the entire distribution of returns, rather than focusing solely on downside risk. It compares the probability-weighted average of positive returns to the probability-weighted average of negative returns. This metric provides a comprehensive view of risk, but it may not be as specific in assessing downside risk as the Sortino Ratio.

The Upside Potential Ratio evaluates the potential for positive returns. It compares the average return of positive periods to the average return of all periods. While this measure provides insights into the upside potential of investments, it doesn't explicitly address downside risk like the Sortino Ratio does.