The Sortino Ratio Explained: Formula, Calculation & Examples

What is the Sortino ratio?

The Sortino ratio is a simple way to calculate how well an investment is performing when you specifically look at risk. Although it is similar to the Sharpe ratio, it doesn’t look at all of the different types of volatility (both the good and the bad). Instead, it only looks at the downside risk – the kind of risk that investors actually worry about, such as financial loss.

To calculate the Sortino ratio, you have to look at the investments return above a risk-free date and then divide it by the actual downside risk (how much the returns ip below a certain threshold). A higher Sortino ratio can mean that the investment is delivering better returns for the level of downside risk it’s actually raking on.

Because of this downside focus, the Sortino ratio is often used by investors to assess a strategy’s performance while paying close attention to potential losses.

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 by using the same formula as standard deviation. However, it only takes into account the actual returns that are below the target rate of return (T).

Without scaring you – the calculation is:

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:

1. Calculate the squared difference between the actual returns (R) and the target return rate (T) for each period of investment.
2. Sum up the squared differences for all periods.
3. Divide the sum by the number of periods.
4. Take the square root of the result to obtain the downside deviation.

Why is the Sortino ratio needed for small businesses?

Running a small business can often mean making tough choices – which are even more problematic when you have limited resources. While it is necessary to take risks for growth, small businesses can’t often afford big losses. Because of this, managing risk is essential.

The Sortino ratio is perfect for this. It is a simple and effective way to tell how well an investment is performing, but with a specific focus on the kind of risk that matters most – the chance of losing money! Unlike other financial metrics, the Sortino ratio only looks at the downside, as we’ve previously mentioned.

This is enormously helpful for small businesses. You can compare different investment options and see which are delivering the desired returns without actually exposing too much risk.

What does the Sortino ratio actually tell you?

Businesses will often compare the Sortino ratio to the Sharpe ratio – another common performance measure. The key difference is that the Sharpe ratio specifically looks at all potential volatility, while the Sortino ratio only focuses on the negative returns – because most small businesses aren’t worried about making more money than expected.

A higher Sortino ratio means that your business is getting better returns for the amount of downside risk that you’re taking. It is especially helpful if your main concern is avoiding losses – not just chasing the highest potential profit.

However, despite the effectiveness of the ratio, it isn’t the only thing to consider. It works best when used alongside other tools and financial benchmarks, and the way you define your “downside” (the return threshold you set) can affect the results – so it is definitely important to be consistent when comparing options.

What is a good Sortino ratio?

Unfortunately, there is no answer that fits all businesses as it depends on your goals and risk. Generally, the higher the ratio, the better. It means that you’re earning more without too much negative risk.

But context still matters. What’s “good” for one type of investment may not be as impressive in another industry. That’s why it’s best to look at the Sortino ratio as part of a bigger picture, comparing it to similar strategies and weighing it alongside other financial metrics.

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 work out the Sortino ratio for different portfolios, your business will need to understand what the downside risk-adjusted return actually is. That means we need to look at the return that is above the minimum acceptable level – often named the MAR – and then dividing it by the downside deviation.

In this case, we’re assuming the MAR is 2%, which is pretty standard as it reflects a typical risk-free rate of return.

So, let’s take a look at Portfolio A first. We have the below calculation:

Downside risk-adjusted return = (10% – 2%) / 5% = 1.6

Now for Portfolio B:

Downside risk-adjusted return = (10% – 2%) / 7% = 0.857

Once you have these numbers in hand, we can calculate the ratio as previously discussed:

So for Portfolio A, that gives us:

Sortino ratio = 1.6 / 5% = 0.32

And for Portfolio B:

Sortino ratio = 0.857 / 7% = 0.12

As you may be able to guess, this tells us that Portfolio A has a higher ratio, so can suggest better returns relative to the downside risk!

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?

Financial forecasting software can be incredibly useful for analysing investment opportunities. They may not be a perfect substitute for the Sortino ratio, which actively measures risk, but they are excellent in providing additional context.

Consider a financial modelling tool like Brixx. It can provide a comprehensive analysis on an investment’s performance, taking into account a whole range of factors. Using Brixx, investors can gain a better understanding of risk and returns.

While a financial modelling tool can be enormously helpful for investment analyusis, it should be used in conjunction with techniques such as the Sortino ratio to ensure that investors are fully evaluating an investment.

Get started with Brixx today to see how this can work for you.