This ratio is used to measure the level of risk in a . The higher the Sortino ratio, the better a portfolio has performed relative to the risk taken. It is often used to compare the risk taken between different portfolios to achieve a certain .
It is necessary to ground the Sortino ratio into context by comparing a fund’s Sortino ratio with that of another , , or category to determine whether a Sortino ratio is high or low.
For example, comparing the 10-year Sortino ratios of two (fictional) funds in the same category – Alpha Growth and Beta Value – reveals that the latter, with a ratio of 1.24, has generated a significantly higher return given its downside volatilityWhat is price volatility? Volatility is the price fluctuatio... More than did the former, which had a Sortino ratio of 0.96.
The Sortino ratio tells us whether a portfolio’s returns are due to smart decisions or a result of excess risk.
Sortino vs. Sharpe ratio
The Sortino ratio is similar to the , however, it uses a different method of calculation. It uses downside deviation at the denominator instead of standard deviation. This is because the standard deviation does not discriminate between up and down .
By utilising this value, the Sortino ratio only penalises for “harmful” volatility. The Sortino ratio discards any upside deviation – the “excessive” profit. It asks the investorAn investor is someone who spends capital with the expectat... More to set a minimum acceptable rate of return (MAR), which is a return that he/she would be comfortable with. Any return above the MAR is not included for the purpose of calculating the Sortino Ratio.
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The formula for the Sortino ratio
The ratio was developed by Frank A. Sortino. It is calculated by:
- Subtracting the risk-free interest rateWhat are interest rates in trading? When one party lends mo... More – for instance, the one given by the 10-year US Treasury bond – from the rate of return of a portfolioWhat is a trading portfolio? When an investor holds a grou... More;
- Dividing the result by the downside deviation of the portfolio returns (note that this is different from the standard deviation used in the Sharpe ratioDeveloped in 1966 by Nobel Laureate William Sharpe, the rati... More).
The formula is as follows:
Sortino ratio = (Rp – Rf) / σd
Rp = expected portfolio returns
Rf = risk-free interestWhat is interest? In finance and trading, interest is a fe... More rate
σd = downside deviation of the portfolio
How to use the Sortino ratio
Funds that cite the Sortino ratio are usually those with the least tolerance for risk. In these cases, the Sortino ratio may be presented as a compliment to an investment that is risk-averse. This ratio allows investorsWhat are value stocks? A value company is a company that app... More to assess risk in a focused manner than simply looking at excess returns to total volatility.
Only when you compare one portfolio’s Sortino ratio with that of another portfolio do you get a feel for its risk-adjusted return. When used in conjunction with other measures, the Sortino ratio can help investorsWhat are value stocks? A value company is a company that app... More develop a strategy that matches both their return needs and risk tolerance.
