What is the Sortino ratio?
The Sortino ratio is a risk-adjusted performance measure that is similar to the Sharpe ratio. However, while the Sharpe ratio uses the standard deviation of returns to calculate the risk, the Sortino ratio only considers the downside risk, which is defined as the standard deviation of negative returns.
The Sortino ratio is calculated as the excess return (return above a risk-free rate) divided by the downside risk. The higher the Sortino ratio, the better the risk-adjusted performance.
The Sortino ratio is often used by investors and fund managers to evaluate the performance of an investment strategy or a portfolio, especially in cases where the downside risk is of particular concern.
Sortino ratio formula
The formula for the Sortino ratio is:
Sortino ratio = (Rp – T) / Dd
Where:
- Rp = the average return of the investment or portfolio
- T = the target rate of return (usually the risk-free rate)
- Dd = the downside deviation of the investment or portfolio
The downside deviation (Dd) is calculated using the same formula as standard deviation, but only takes into account returns that are below the target rate of return (T). We don’t want to scare you, but mathematically, it can be expressed as:
Dd = sqrt([sum of (Ri – T)^2 / N] * [N / (N-1)])
Where:
- Ri = the return for each period
- T = the target rate of return
- N = the number of periods
Once the target return rate is determined, you can calculate the downside deviation as follows:
- Calculate the squared difference between the actual returns (R) and the target return rate (T) for each period of investment.
- Sum up the squared differences for all periods.
- Divide the sum by the number of periods.
- Take the square root of the result to obtain the downside deviation.
Why is the Sortino ratio needed for small businesses?
Taking risks is a critical part for any business. However, small businesses often have limited resources and cannot afford to take significant losses. Therefore, it is important for them to assess the potential downside risk of their investments and make informed decisions. The Sortino ratio provides a useful tool for small businesses to measure their investment performance in a way that accounts for the downside risk they face.
In addition, the Sortino ratio can also help small businesses compare the performance of different investment strategies or portfolios. By looking at the Sortino ratio of each strategy or portfolio, small business owners can identify which ones are generating the highest returns for a given level of downside risk.
Overall, the Sortino ratio is a valuable metric for small businesses because it provides a way to evaluate investment performance that takes into account the potential downside risk, which is particularly important for businesses with limited resources.
What the Sortino ratio can tell you
Unlike the Sharpe ratio, which takes into account both the upside and downside variability of an investment’s return, the Sortino ratio only considers the downside volatility.
The Sortino ratio is calculated by taking the portfolio’s excess return over the risk-free rate, and dividing it by the portfolio’s downside deviation. Downside deviation is the standard deviation of negative returns, or returns below a certain threshold.
The Sortino ratio is useful for investors who are particularly concerned about downside risk, and want to evaluate the performance of an investment with that in mind. A higher Sortino ratio indicates that the investment has generated higher returns for the amount of downside risk taken on.
However, it’s important to note that the Sortino ratio is just one tool for evaluating investment performance, and should be used in conjunction with other financial metrics and industry benchmarks. Additionally, the threshold used to define negative returns can have a significant impact on the calculated Sortino ratio, so it’s important to carefully consider the threshold used when comparing different investments.
What is a good Sortino ratio?
There is no specific threshold for what constitutes a good Sortino ratio, as it can vary depending on the investor’s risk tolerance and investment objectives. Generally, a higher Sortino ratio is better, as it indicates that the investment is generating higher returns for the same level of downside risk or lower risk for the same level of return.
However, the interpretation of the Sortino ratio should be done in the context of the specific investment being evaluated and compared against similar investments in the same asset class or industry. Moreover, investors should not rely solely on one metric but rather consider a range of factors when making investment decisions.
Limitations of the Sortino ratio
While the Sortino Ratio is useful for focusing on downside risk, it has some drawbacks that investors should consider.
1. Ignores positive volatility
The ratio does not account for upside gains, which means it may not always give a full picture of a portfolio’s performance.
2. Dependent on accurate downside risk data
Calculating the downside deviation requires precise data, and incorrect inputs can lead to misleading results.
3. Less effective for short-term investors
The Sortino Ratio works best for long-term investment strategies. Short-term traders may not benefit as much from this metric.
4. Not always comparable across assets
Comparing Sortino Ratios between different asset classes (e.g., stocks vs. real estate) can be tricky because risk characteristics vary.
Example of the Sortino ratio
Here’s a simple example to calculate the Sortino ratio:
Assume you have two investment portfolios, A and B, with the following characteristics:
Portfolio A:
- Annual return: 10%
- Downside deviation (or downside risk): 5%
Portfolio B:
- Annual return: 10%
- Downside deviation: 7%
To calculate the Sortino ratio for each portfolio, we first need to determine the downside risk-adjusted return, which is the excess return of the portfolio over a minimum acceptable return (MAR) divided by downside deviation.
The MAR is typically defined as the risk-free rate of return, which is assumed to be 2% in this example.
For Portfolio A, the downside risk-adjusted return is calculated as follows:
Downside risk-adjusted return = (10% – 2%) / 5% = 1.6
For Portfolio B, the downside risk-adjusted return is calculated as follows:
Downside risk-adjusted return = (10% – 2%) / 7% = 0.857
The Sortino ratio is then calculated by dividing the downside risk-adjusted return by the downside deviation:
- Sortino ratio for portfolio A = 1.6 / 5% = 0.32
- Sortino ratio for portfolio B = 0.857 / 7% = 0.12
Therefore, Portfolio A has a higher Sortino ratio, indicating better risk-adjusted returns.
How to use the Sortino ratio in investment decisions
The Sortino ratio helps investors make better financial decisions by evaluating risk-adjusted returns in a more precise way. Here’s how it can be applied:
1. Comparing two investment options
If you’re choosing between two mutual funds, the one with the higher Sortino ratio is likely offering better returns per unit of downside risk.
2. Assessing portfolio risk
Investors who want to reduce risk exposure can use the Sortino ratio to identify funds or strategies that minimize downside losses.
3. Retirement and wealth planning
Since retirees often prioritise avoiding large losses, using the Sortino ratio helps select investments with lower downside risk.
4. Fine-tuning investment strategies
Hedge funds and active investors use the Sortino ratio to adjust portfolio allocations based on historical downside deviations.
Can you use a financial modelling instead of the Sortino ratio?
While financial modelling can be a useful tool for analyzing investment opportunities, it is not a direct substitute for the Sortino ratio. The Sortino ratio specifically measures an investment’s performance relative to downside risk, which can be an important consideration for investors who are risk-averse or seeking to limit their losses.
That being said, financial modelling tool can provide a more comprehensive analysis of an investment’s potential performance, taking into account a range of factors such as market trends, economic conditions, and industry-specific risks. By using financial modelling tools like Brixx, investors can gain a more nuanced understanding of an investment’s potential risk and return profile.
In summary, while financial modelling can be a useful tool for investment analysis, it should be used in conjunction with other risk management techniques such as the Sortino ratio to ensure that investors are fully evaluating an investment’s potential risks and returns.
Frequently asked questions
Sortino ratio vs Sharpe ratio
The Sortino ratio and the Sharpe ratio are both used to measure risk-adjusted returns, but they focus on risk in different ways. Understanding their differences helps investors choose the right tool for their analysis.
| Factor | Sortino ratio | Sharpe ratio |
|---|---|---|
| Risk considered | Only downside risk (negative volatility) | Total volatility (both upside and downside) |
| Formula | (Return – Risk-Free Rate) ÷ Downside Deviation | (Return – Risk-Free Rate) ÷ Standard Deviation |
| Best For | Investors who want to avoid losses | Investors who want a balanced view of risk |
| Weakness | Ignores upside volatility, which may be useful in some strategies | Penalises both gains and losses equally |
| Use cases | Retirement planning, downside protection strategies | General investment analysis, comparing different portfolios |
