Sortino ratio is a variant of the Sharpe ratio that uses the asset’s standard deviation of negative portfolio returns—downside deviation—rather than the total standard deviation of portfolio returns to distinguish damaging volatility from total overall volatility.
The Sortino ratio is calculated by subtracting the risk-free rate from the return on an asset or portfolio, then dividing the result by the asset’s downside deviation. Frank A. Sortino is the name of the ratio.
The Sortino ratio differs from the Sharpe ratio in that it only takes into account the standard deviation of the downside risk, rather than the total (upside + downside) risk.
Because the Sortino ratio only considers the negative departure of a portfolio’s returns from the mean, it is regarded to provide a more accurate picture of its risk-adjusted performance, as positive volatility is a benefit.
Investors, analysts, and portfolio managers can use the Sortino assess an investment’s return for a certain degree of unfavourable risk.
The Sortino Ratio and What It Can Tell You
Investors, analysts, and portfolio managers can use the Sortino ratio to assess an investment’s return for a certain degree of unfavourable risk.
This ratio avoids the difficulty of using total risk, or standard deviation, as a risk measure, which is significant because upside volatility is favourable to investors and isn’t a feature that most investors are concerned about.
An Example of Using the Sortino Ratio
A greater Sortino ratio outcome is better, just like a higher Sharpe ratio.
When comparing two similar investments, a rational investor would choose the one with the higher Sortino ratio since it indicates that the investment is receiving a higher return per unit of poor risk.
Assume Mutual Fund X has a 12-percent annualised return with a ten-percentage-point downside deviation.
Mutual Fund Z offers a ten percent annualised return and a seven percent downside deviation. 2.5 percent is the risk-free rate.
For both funds, the Sortino would be determined as follows:
Despite the fact that Mutual Fund X has a 2 percent higher annualised return than Mutual Fund Z, because to their downside deviations, Mutual Fund X is not earning that return as effectively as Mutual Fund Z.
Mutual Fund Z is the superior investment option based on this metric.
While the risk-free rate of return is commonly used in calculations, investors can also utilise expected return.
The investor should be constant in terms of the type of return in order to maintain the formulas correct.
What Is the Difference Between the Sortino and Sharpe Ratios?
By dividing excess return by the downside deviation rather than the overall standard deviation of a portfolio or asset, the Sortino improves on the Sharpe ratio by isolating downside or negative volatility from total volatility.
The Sharpe ratio penalises an investment for taking on too much risk, resulting in favourable returns for investors.
Choosing which ratio to utilise, however, is dependent on whether the investor wants to focus on total or standard deviation, or just downside deviation.
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