Business, Legal & Accounting Glossary
The Sortino Ratio is a tool, like the Sharpe Ratio, that allows investors to gauge risk-adjusted returns on an asset or portfolio of assets. Unlike the Sharpe Ratio, however, the Sortino Ratio makes a distinction between upward and downward volatility. In other words, the Sortino Ratio only counts the downward volatility as risk.
The Sortino Ratio was developed by Frank A. Sortino as an adjustment to the Sharpe Ratio. Sortino saw a major flaw in the Sharpe ratio as a risk-adjusted rate of return because it counted upside deviation as unfavourable. Sortino knew that investors value upside deviations and only see downside deviations as an actual risk. The Sortino Ratio reflects this bias by only taking downside deviation into account.
The Sortino Ratio is calculated by dividing the difference between the expected rate of return and the risk-free rate by the standard deviation of negative asset returns. The formula for the Sortino Ratio only differs from the Sharpe ratio in that it uses portfolio downside deviation instead of portfolio standard deviation as the denominator.
The Sortino Ratio measures the risk-adjusted return of an investment asset, portfolio or strategy.
Sortino Ratio 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 Sharpe ratio variant that distinguishes harmful volatility from total overall volatility by using the asset’s standard deviation of negative portfolio returns—downside deviation—rather than the total standard deviation of portfolio returns. The Sortino ratio calculates the return on an asset or portfolio, subtracts the risk-free rate, and divides the result by the asset’s downside variance. Frank A. Sortino inspired the ratio’s name.
Sortino Ratio=σdRp−rf
where:
The Sortino ratio is a valuable tool for investors, analysts, and portfolio managers to estimate the return on an investment for a given degree of unfavourable risk. Because this ratio only considers the downside variation as a risk factor, it avoids the issue of using total risk, or standard deviation, which is significant because upside volatility is advantageous to investors and isn’t a factor that most investors are concerned about.
A greater Sortino ratio result is better, just like a higher Sharpe ratio score. When comparing two similar investments, a reasonable investor would prefer the one with a greater Sortino ratio since it indicates that the investment earns more return per unit of poor risk than it assumes.
By dividing excess return by the downside deviation rather than the overall standard deviation of a portfolio or asset, the Sortino ratio improves on the Sharpe ratio by isolating downside or negative volatility from total volatility.
The Sharpe ratio punishes the investment for taking a lot of risk, which makes it profitable for investors. It also depends on whether the investor wants to look at total or standard deviation, as well as just the downside deviation, so which ratio to use is important.
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This glossary post was last updated: 19th January, 2022 | 0 Views.