Sortino Ratio Meaning Formula Example Vs Sharpe Ratio

Sortino Ratio Meaning

You are free to use this image on you website, templates, etc., Please provide us with an attribution linkHow to Provide Attribution?Article Link to be HyperlinkedFor eg:Source: Sortino Ratio (wallstreetmojo.com)

The ratio, in simple words, helps determine additional returns that investors might generate for each unit of downside risk in the market. It is similar to other performance metrics, like the Sharpe and Treynor ratios. The only difference is in the computation of risk, which is not the total risk but only the risk associated with downward price movement.

Key Takeaways

Sortino ratio is yet another portfolio performance tool that helps investors and analysts assess the excess returns expected for each unit of downside risk they take.The higher the ratio, the better the expected performance of the portfolio.It is preferred over other risk-adjusted return assessment tools as it considers only the downside deviation and not the total volatility, which includes both upside and downside risks.A negative ratio suggests that investors will receive no rewards for the risks taken.

Understanding Sortino Ratio

Sortino ratio is obtained when users, who are mostly investors, take into account only the downside risk and not the total risk, which includes both the upside and downside deviations. It is, therefore, considered a more effective method of calculating risk-adjusted returns.

Through this ratio, they get an opportunity to determine the additional returns they can expect from an investment for every unit of downside deviation, which is concerned with the expected loss it is likely to incur concerning the market fluctuations.

Investors who spend on mutual funds and other financial instruments are more concerned about the downward volatility as they know a positive fluctuation will only reap profits for them. Hence, studying the downside risk becomes more important than figuring out the overall market volatility.

With this ratio, the investors can assess the excess returns, particularly for each unit of downside risk. This gives them a better and clearer picture of returns that a particular investment may generate. As a result, they get a chance to make well-informed and wise decisions.

A high Sortino ratio indicates better excess returns despite the expected downward volatility. Its only limitation is that there should be enough bad volatility events to calculate a downward deviation to be statistically significant.

Formula

To calculate the Sortino ratio, investors must be aware of the actual or expected returns on the investments, the rate of returns on the investment of the same value without risk also termed risk-free returns, and the downside deviation.

Investors can use these details and put the figures in the Sortino ratio formula below:

Here ’R’ is the value of the expected portfolio returns, while ‘r’ is the rate of return for a risk-free investment.

Example

Suppose there are two different investment portfolioInvestment PortfolioPortfolio investments are investments made in a group of assets (equity, debt, mutual funds, derivatives or even bitcoins) instead of a single asset with the objective of earning returns that are proportional to the investor’s risk profile.read more schemes, A and B, with 10% and 15% annualized returns, respectively. Assuming that the downward deviation of A is 4%, whereas for B is 12%. Also, considering the fixed deposit risk-free rateRisk-free RateA risk-free rate is the minimum rate of return expected on investment with zero risks by the investor. It is the government bonds of well-developed countries, either US treasury bonds or German government bonds. Although, it does not exist because every investment has a certain amount of risk.read more of 6%.

Sortino ratio calculation for A is: (10-6)/4 = 1Sortino ratio calculation for B is: (15-6)/12 = 0.75

Even though B has a greater annual return than A, its ratio is less than the latter. So, suppose investors are more concerned about the downside risksDownside RisksDownside Risk is a statistical measure to calculate the loss in a security’s value due to variations in the market conditions. Also, it refers to the uncertainty level of realized returns being much lesser than the anticipated ones. read more associated with the scheme than the expected returns. In that case, they will go for scheme A as it earns more return per unit of bad risk and has a greater probability of avoiding any large loss.

Uses

Investors, analysts, portfolio managers, or whoever desires to assess the extent of excess return on each unit of negative deviation can use Sortino ratios. The ratio effectively differentiates between good and bad variances by calculating a downward deviation, helping retail investorsRetail InvestorsA retail investor is a non-professional individual investor who tends to invest a small sum in the equities, bonds, mutual funds, exchange-traded funds, and other baskets of securities. They often take the services of online or traditional brokerage firms or advisors for investment decision-making.read more with specific goals make effective investment decisions, keeping the target rates of return in mind.

It also acts as a useful tool for portfolio or fund managers, allowing them to measure their performance. It ignores all the positive variances and provides a more accurate picture of returns considering the market volatility.

Sharpe Ratio vs Sortino Ratio

Sortino and Sharpe ratio formulaSharpe Ratio FormulaThe Sharpe ratio formula calculates the excess return over the risk-free return per unit of the portfolio’s volatility. The risk-free rate of return gets subtracted from the expected portfolio return and is divided by the standard deviation of the portfolio. Sharpe ratio = (Rp – Rf)/ σpread more are similar in almost all aspects, given the purpose they fulfill. Both these ratios help investors check how a portfolio or asset is likely to perform despite the market fluctuations. As a result, they focus on the volatility and derive respective results, be it assessing the risk or additional returns.

The Sharpe ratio determines the returns based on the total volatility in the market, which includes upside and downside risks. On the other hand, the Sortino ratio only considers the downside risks for assessing additional returns.

As the downside risk is a major concern for investors, they prefer Sortino ratios. The choice, however, will depend on individual investors and their goals, objectives, and convenience.