UK Accounting Glossary
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 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.
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This glossary post was last updated: 5th February 2020.