Understanding the Sortino Ratio: Maximizing Your Investment’s Risk-Adjusted Performance
The Sortino Ratio is a valuable tool for investors, providing a method to evaluate the risk-adjusted return of an asset or portfolio by focusing specifically on harmful volatility. Unlike the Sharpe Ratio which considers overall volatility, the Sortino Ratio uses only the downside deviation, which is the standard deviation of negative portfolio returns. Named after Frank A. Sortino, this ratio provides a clearer picture of an asset’s true performance related to adverse risk.
Key Takeaways
- The Sortino Ratio focuses solely on the downside risk, ignoring the upside volatility which is actually beneficial for investors.
- By using downside deviation, it offers a better measure of a portfolio’s risk-adjusted performance as it emphasizes the potential for losses rather than total volatility.
- Investors, analysts, and portfolio managers can better evaluate and compare investments by understanding the specific levels of bad risk involved.
Formula and Calculation of Sortino Ratio
Sortino Ratio = \frac{R_p - r_f}{\sigma_d}
Where:
- (R_p) = Actual or expected portfolio return
- (r_f) = Risk-free rate
- (\sigma_d) = Standard deviation of the downside
What the Sortino Ratio Can Tell You
This ratio allows investors to discern the efficiency of an investment in terms of return per unit of negative risk taken. Utilizing only the downside deviation addresses the issue of penalizing positive volatility (good risk) which isn’t a concern for investors.
Example of How to Use the Sortino Ratio
Imagine, for instance, that we have two mutual funds: Mutual Fund A and Mutual Fund B. Mutual Fund A offers an annualized return of 12% with a downside deviation of 10%. Mutual Fund B provides a return of 10% with a downside deviation of 7%. The risk-free rate is 2.5%. The Sortino ratios would be calculated as follows:
For Mutual Fund A:
Sortino (A) = \frac{12\% - 2.5\%}{10\%} = 0.95
For Mutual Fund B:
Sortino (B) = \frac{10\% - 2.5\%}{7\%} = 1.07
Although Mutual Fund A has a higher return, Mutual Fund B demonstrates a better return per unit of bad risk based on its Sortino Ratio, making it a superior investment option.
The Difference Between the Sortino Ratio and the Sharpe Ratio
While the Sharpe Ratio provides a measure of return relative to total volatility, the Sortino Ratio enhances this by focusing on negative volatility only. By doing so, it avoids penalizing investments for positive volatility which benefits investors. Deciding which ratio to use depends on whether the analysis aims to focus on total volatility or just downside deviations.
Related Terms: Sharpe Ratio, Risk-Free Rate, Downside Deviation, Portfolio Return.
References
- CME Group. “Sortino: A ‘Sharper’ Ratio”. Pages 2-3.
