Sortino Ratio – what is a good number (Formula, Calculation, and Definition)

Named after Frank A. Sortino, the economist that created it, the Sortino Ratio is another performance metric for measuring the performance of an investment relative to the amount of risk involved. The ratio is considered a variation of the Sharpe Ratio, but what exactly is it?

Sortino Ratio is a performance metric that measures the risk-adjusted return of an investment using only the downside risk. Considered a variation of the Sharpe Ratio, Sortino Ratio uses only the standard deviation of the negative returns as its risk measure in the calculation. A good Sortino Ratio is one with a score of 2 or above.

One of the ratios for measuring risk-adjusted returns of a particular investment scheme, such as a mutual fund, the Sortino Ratio is a variation of the Sharpe Ratio that differentiates harmful market fluctuations from total overall volatility by using the asset’s standard deviation of negative portfolio returns, called downside deviation, instead of the total standard deviation of portfolio returns.

Sortino ratio vs Sharpe ratio

The Sharpe Ratio and the Sortino Ratio are both risk-adjusted evaluations of return on investment that are relevant to mutual fund investors. These ratios make use of similar formula, so the Sortino Ratio is a variation of the Sharpe. As a modification of the Sharpe Ratio, Sortino Ratio penalizes only those returns falling below a user-specified target or required rate of return (rf), which is important for investors who want to assess the performance of their scheme. Meanwhile, the Sharpe Ratio penalizes both upside and downside volatility equally, which may not be suitable for some investors.

Interpretation of the Sortino ratio

By definition and interpretation, the Sortino ratio is a statistical tool that measures the performance of a mutual fund relative to the downward deviation. Unlike Sharpe, it doesn’t consider the upside volatility. It is gotten by subtracting the target rate of return or the risk-free rate of return from the expected or actual return of a scheme and dividing it by the standard deviation of the downside returns. So, it is the extra return over and above the target rate of return or risk-free rate of return per unit downward risk for investors.

But why does the Sortino Ratio achieve by excluding the upside volatility? Well, upside volatility is what investors are aiming to get when investing in a portfolio, so it should not be seen as a risk to the portfolio, which is why it is excluded from the equation. Because of this, many financial analysts believe that the Sortino Ratio is a better measure of risk-adjusted returns than the Sharpe Ratio.

As investors, you already know that the risk in an investment scheme means the variation in the scheme’s returns. The more the returns fluctuate, the riskier the investment scheme is deemed to be. This volatility of an investment scheme’s returns is measured with the standard deviation of the returns over a given period. While the Sharpe Ratio considers both the upside and downside returns, the Sortino Ratio considers only the downside returns.

How to calculate Sortino Ratio

Sortino ratio is a statistical tool to measure the risk-adjusted performance of an investment portfolio relative to the standard deviation of negative asset return, also called the downward deviation. It is calculated by dividing the difference between the portfolio’s return and the risk-free rate of return or the target rate of return with the standard deviation of the negative returns. The numerator of the Sortino ratio equation is normally your portfolio’s return minus the target rate of return, previously known as the minimum acceptable return (MAR), but some analysts simply use the risk-free rate as the minimum acceptable rate of return. The denominator is the standard deviation of the negative returns, which is often referred to as downside deviation.

The standard Sortino Ratio formula is given as:

S = (R – T) / DR

Where:

S = Sortino Ratio

R = Portfolio or strategy’s average realized return

T = the required rate of return