Sortino Ratio

The Sortino ratio is a variation of the Sharpe ratio that differentiates between harmful volatility (downside risk) and overall volatility by only focusing on the downside risk of an investment. It measures the risk-adjusted return of an investment, considering only negative price fluctuations, which are the main concern for investors. A higher Sortino ratio indicates better risk-adjusted performance, as it shows the return achieved relative to only the downside risk.

Example

An investment fund has an average return of 10% and a downside deviation of 5%. Its Sortino ratio is 2, meaning it generates two units of return for every unit of downside risk.

Key points

• Measures risk-adjusted return, focusing only on downside risk.

• A variation of the Sharpe ratio, providing a more precise risk assessment.

• Higher ratios indicate better performance relative to negative volatility.

Quick Answers to Curious Questions

Why is the Sortino ratio preferred over the Sharpe ratio in some cases?

It only penalizes downside volatility, making it a better measure for investors concerned with losses rather than overall volatility.

What is downside risk, and why is it crucial in the Sortino ratio?

Downside risk refers to potential losses, which are the focus of the Sortino ratio, making it more relevant to risk-averse investors.

How does the Sortino ratio help in comparing investments with similar returns but different risk profiles?

It offers a clearer picture of how well returns compensate for the risk of losses, helping investors choose between investments with the same return but different downside risks.