Calculate the Sortino ratio to measure risk-adjusted returns by focusing on downside volatility rather than total volatility. This metric helps investors evaluate portfolio performance relative to the risk of negative returns.
Sortino ratio is a risk-adjusted performance metric that measures the excess return of an investment per unit of downside risk, focusing only on negative volatility.
Sortino Ratio = (Portfolio Return − Risk-Free Rate) / Downside Deviation
A higher Sortino ratio indicates better risk-adjusted returns relative to downside risk. Generally:
Use the Sortino ratio to compare different investments or portfolios:
| Aspect | Sortino Ratio | Sharpe Ratio |
|---|---|---|
| Volatility Measure | Downside deviation only | Total standard deviation |
| Risk Focus | Downside risk | Total risk |
| Best For | Risk-averse investors | General risk assessment |
| Calculation | (Return - Risk-free) / Downside Dev | (Return - Risk-free) / Std Dev |
Downside deviation measures the volatility of returns that fall below a target or goal, usually the risk-free rate or a minimum acceptable return. The calculation involves the following steps:
If you don’t have the historical returns data to calculate downside deviation, you can estimate it for most portfolios as 60-80% of the total standard deviation.
Calculating downside deviation requires historical return data. If the data is not available or insufficient, the Sortino ratio may not be accurate.
The Sortino ratio is sensitive to the choice of target return. The same investment can have different Sortino ratios depending on the target return.
The Sortino ratio doesn’t measure all types of risk, such as liquidity risk, concentration risk, etc.
