Sortino Ratio: Its Definition, Formula, and Example


Key Takeaway:

  • Sortino ratio is a performance measure that evaluates investment returns in relation to downside risk.
  • The formula for Sortino ratio calculation involves comparing the return of an investment to its target (minimum acceptable) return, and divides this by the downside deviation.
  • An example of Sortino ratio calculation can be illustrated by using a hypothetical portfolio of stocks to show its returns and downside risk.
  • Interpretation of Sortino ratio results can be based on threshold return and target rate of return, where a higher ratio indicates better risk-adjusted performance.
  • The advantages of using Sortino ratio include providing a more comprehensive and accurate measure of risk-adjusted performance, while limitations may involve its reliance on historical data and single-period analysis.
  • Overall, understanding the Sortino ratio can assist investors in making informed investment decisions that align with their risk tolerance and objectives.

Are you looking for a way to measure the performance of your investments? Our article on the Sortino Ratio provides you with all the information you need to understand how it works and how you can use it to make better decisions. With this in-depth guide, you'll have all the tools to improve your portfolio's performance.

Definition of Sortino Ratio

The Sortino Ratio is a risk-adjusted performance measure used to evaluate the return of an investment relative to the downside risk, which is calculated by dividing the excess return by the downside deviation. This metric is particularly useful for investors who are risk-averse and want to focus on the negative volatility of an investment.

Using the Sortino Ratio, investors can identify investments that provide more stable returns during market turbulence. In simpler terms, this metric helps investors understand how much return they can expect relative to the amount of risk they are taking on.

To calculate the Sortino Ratio, one needs to first determine the expected return of the investment and then determine the downside deviation of the investment. The downside deviation is the difference between the expected return and the minimum acceptable return, which is usually the risk-free rate. After determining these two values, the Sortino Ratio can be calculated by dividing the excess return by the downside deviation.

It s important to note that the Sortino Ratio is not a perfect metric and should be used in conjunction with other measures of risk and return. Additionally, this ratio is only effective when used to compare investments with similar characteristics.

Investors seeking to maximize returns while minimizing downside risk should consider using the Sortino Ratio to evaluate their investments ability to weather market turbulence. By understanding the downside risk of an investment, investors can make more informed decisions and potentially avoid significant losses.

Don't miss out on taking advantage of this valuable tool. Incorporate the Sortino Ratio into your investment evaluation processes to ensure you are making well-informed, risk-averse decisions.

Formula for Sortino Ratio Calculation

The Sortino Ratio, also known as the downside deviation, measures the risk-adjusted return of an investment. To calculate the formula, follow these three steps:

  1. Determine the desired period for measurement, such as a month or a year.
  2. Calculate the average excess return of the investment portfolio or asset above the chosen benchmark for the period.
  3. Divide the average excess return by the downside deviation for the period.

The formula for the Sortino Ratio calculation can be expressed as average excess return divided by downside deviation. It is a useful tool for investors who want to assess the risk of their investment and compare it to their desired level of risk tolerance. For example, if an investor wants a low-risk investment with a high return, they may look for assets with a higher Sortino Ratio. While it is important to note that the Sortino Ratio is not the only tool investors should use to make investment decisions, it can provide valuable insights.

A notable detail about the Sortino Ratio is that it considers only downside risk instead of overall volatility. This makes it a valuable tool for investors who prioritize limiting downside risk. The Sortino Ratio was introduced by Frank A. Sortino, a mathematician and professor who spent his career studying investment risk and performance.

Example of Sortino Ratio Calculation

The Sortino Ratio Calculation Example showcases how the ratio is calculated in practice. The table below illustrates the method and steps involved in the calculation.

Investment Strategy Average Annual Return Downside Standard Deviation Strategy A 15% 8% Strategy B 12% 5%

To calculate the Sortino ratio, we first subtract the risk-free rate of return from the average annual return and then divide this value by the downside standard deviation. Suppose the risk-free rate of return is 2%, then the Sortino ratios for Strategy A and Strategy B would be:

Sortino Ratio for Strategy A: (15% - 2%) / 8% = 1.63

Sortino Ratio for Strategy B: (12% - 2%) / 5% = 2.00

One notable aspect of the Sortino ratio is that it only considers the downside risk. This contrasts with other performance metrics, such as the Sharpe ratio, which takes both upside and downside risk into account.

It is worth noting that the Sortino ratio was developed by Frank A. Sortino and is widely used in finance for evaluating the risk-adjusted return of investment portfolios.

Overall, the Sortino Ratio Calculation Example provides a useful demonstration of the practical application and value of this ratio for investors and financial professionals.

Interpretation of Sortino Ratio Results

The Sortino Ratio is a measure of risk-adjusted returns for an investment. The ratio takes into account not only the overall return of an investment but also the downside risk or volatility. When interpreting Sortino Ratio results, investors can use the ratio to compare the risk-adjusted performance of different investments. A higher Sortino Ratio indicates a better risk-adjusted return.

Investors can also use the Sortino Ratio to assess the downside risk or volatility of an investment. A lower Sortino Ratio indicates that an investment has higher downside risk. Therefore, investors can use the Sortino Ratio as a tool to better understand the risk-return profile of an investment.

It's essential to interpret Sortino Ratio results in the context of the investment objectives and other metrics like the Sharpe Ratio. Different investment strategies and objectives will require different Sortino Ratio thresholds. For example, conservative investors may prefer a higher Sortino Ratio, while more aggressive investors may tolerate more significant downside risk.

Pro Tip: While the Sortino Ratio is a useful tool for risk assessment, investors should not rely solely on this metric to make investment decisions. It is essential to consider other factors such as market trends, economic indicators, and company fundamentals before investing.

Advantages and Limitations of Sortino Ratio

Sortino Ratio: Pros and Cons of Usage in Investments

Sortino Ratio, while an accurate measure of downside risk, has limitations in comparing two different investments. The ratio may not include factors like market trends and volatility, and at times may give false signals.

A Table of Advantages and Limitations of the Sortino Ratio

Advantages of Sortino RatioLimitations of Sortino Ratio 1. Accurate measure of downside risk1. May not reflect overall market trends 2. Focuses on negative deviation and does not consider positive returns2. May give false signals in certain market conditions 3. Useful for portfolios that hold assets with high-risk profiles3. Not useful in comparing two different investments

Unique Details on the Usage of Sortino Ratio

While Sortino Ratio is useful in assessing downside risk for investors, it should not be the only factor when evaluating investments. Additionally, the ratio's limitations may lead investors to make hasty decisions, so it should be used in conjunction with other metrics.

According to an article on Investopedia, Sortino Ratio is often used by hedge fund managers to evaluate portfolio managers' performance.

Five Facts About Sortino Ratio: Definition, Formula, Calculation, and Example:

  • ✅ Sortino Ratio is a risk-adjusted performance measure used in the field of finance to evaluate the return of an investment compared to its downside risk. (Source: Investopedia)
  • ✅ The formula for Sortino Ratio is (Rp - Rf) / DR, where Rp is the portfolio return, Rf is the risk-free rate, and DR is the downside risk. (Source: Corporate Finance Institute)
  • ✅ Downside risk refers to the measure of volatility in the returns of an investment that falls below a specified threshold or target rate of return. (Source: Wall Street Mojo)
  • ✅ Sortino Ratio is considered a more comprehensive measure of risk as compared to Sharpe Ratio since it only considers the downside risk or the negative volatility of an investment. (Source: The Balance)
  • ✅ Sortino Ratio can be useful for investors in selecting investment options that provide higher returns for a given level of downside risk. (Source: Value Research Online)

FAQs about Sortino Ratio: Definition, Formula, Calculation, And Example

What is the Sortino Ratio?

The Sortino Ratio is a performance measurement tool that helps investors identify the level of risk associated with an investment. This ratio measures the level of return generated by an investment per unit of downside risk, which makes it a useful tool for investors who want to make informed investment decisions.

What is the Formula to Calculate the Sortino Ratio?

The formula to calculate the Sortino Ratio is quite simple. It is calculated by subtracting the risk-free rate of return from the investment return, and then dividing it by the downside deviation. Mathematically, it is represented as: Sortino Ratio = (Return on Investment - Risk-Free Rate of Return) / Downside Deviation

How to Calculate the Downside Deviation?

The Downside Deviation is calculated by taking the square root of the average of the sum of the negative deviations from the average return, which gives us the standard deviation only of negative returns. It is calculated as follows: Downside Deviation = SQRT(Sum of negative (Returns - Average Return)^2 / (Total number of returns - 1))

Can you give an Example of the Sortino Ratio Calculation?

Suppose an investor invests in a mutual fund that generates a return of 20% with a downside deviation of 10% and the risk-free rate of return is 5%. Then calculating the Sortino Ratio for this mutual fund will be as follows: Sortino Ratio = (20 -5) / 10 = 1.5

What are the Advantages of Using Sortino Ratio?

Sortino Ratio is an excellent tool that investors can use to make informed investment decisions. It provides a clear understanding of the performance of the investment while considering the level of risk taken. By measuring the downside risk only, it helps investors in identifying under-performing investments, leading to better portfolio management decisions.

Can the Sortino Ratio be used for Different Investments?

Yes, the Sortino Ratio can be used to measure the performance of any investment with a downside deviation. However, it is essential to note that the Sortino Ratio is most effective when analyzing investments that have a skewed return distribution (i.e., more volatile to the downside). Examples of such investments are hedge funds, commodities, and other alternative investments.