The Sortino ratio is an alternative to the Sharpe ratio, as it isolates the effects volatility has on investments. This ratio is used to determine a portfolio’s performance adjusted for risk, by using the return below a minimally acceptable target.
Basically, the Sortino ratio adjusts the return for the risk of an investment by checking the potential losses instead of the overall volatility – unlike the Sharpe ratio. Therefore, by ruling out the influences of the upside volatility, the true performance of a certain investment is determined.
When compared to the aforementioned Sharpe ratio, the Sortino ratio has as the purpose the delineation between the general market and the harm volatility may cause. This ratio only looks at the downside volatility – and not at the upside one – and only factoring the returns under the minimal acceptable rate that they were posted on within a certain time period.
The Basics of the Sortino Ratio
Unlike the Sharpe ratio, this one does not penalize for volatility. Thus, the returns that exceed the acceptable rate won’t hurt a certain portfolio’s score. It is stated that this formula makes sense indeed, as an investor won’t care about volatility if it’s in his or her favor.
After all, an investor just wants to minimize its negative effects.
Besides investors, people can use the Sortino ratio in order to determine the return that’s needed in order to meet a future financial goal that’s previously specified. In short, someone can use this formula in order to see how much time it will take for them to save up for a down payment for a home or a car.
Calculating the Sortino Ratio
In order to come up with the Sortino ratio, we’ll have to do a division, but only after making a difference. Therefore, we’ll first subtract the minimally acceptable return from the portfolio’s actual return. Then, we’ll divide that result by the standard deviation of the negative asset returns, also known as downside deviation.
Basically, if we remove the minimally acceptable rate of return from the overall expected return of a certain investment, we can determine how much the expectations exceed the minimum rate.
The last part of the formula is used to adjust the expectations for the negative returns.
Usually, investors will make use of the Sortino ratio in order to determine the performance and risk of certain investments in a portfolio – for example, mutual funds.
This ratio also functions as a measuring stick by the investment managers, as the ratio represents the returns in excess that are above the investor’s minimum acceptable rate, a rate that the investment manager was able to achieve for the given period.
Naturally, a higher Sortino ratio is sought after as it shows that a certain investment or portfolio is operating in an efficient manner and that it carries a decreased risk or large sudden loss. Basically, it is believed that the Sortino ratio does things better than the Sharpe ratio, as it evaluates the overall risk of a certain investment.
Of course, an investor decides between the two ratios – if he or she wants to determine the total volatility using the standard deviation, then the Sharpe ratio will be used. On the other hand, if the downside volatility is chosen in order to determine the overall downside volatility, then the Sortino ratio will be used.