The Sortino ratio is a risk-adjusted performance measure that is similar to the Sharpe ratio. It is used to evaluate the performance of an investment by adjusting for the risk taken to generate the return. The higher the Sortino ratio, the better the portfolio’s return relative to the risk it is taking on. It is calculated by subtracting the target return (usually the risk-free rate) from the portfolio return and then dividing the result by the downside deviation. The downside deviation is a measure of the volatility of the negative returns of the portfolio. While the standard deviation in Sharpe ratio considers all fluctuations, the downside deviation only considers negative fluctuations and excludes positive fluctuations.
The formula for the Sortino ratio is:
Sortino ratio = (portfolio return – target return) / downside deviation
For example, let’s say a portfolio has a return of 8% and downside deviation of 2%, and the target return is 2%. The Sortino ratio would be:
(8 – 2) / 2 = 3
A Sortino ratio of 3 indicates that the portfolio is generating a return that is 3 times higher than the level of downside deviation. A Sortino ratio greater than 1 indicates that the portfolio is generating a return that is higher than the level of downside deviation, while a Sortino ratio less than 1 indicates that the portfolio is generating a return that is lower than the level of downside deviation.
The Sortino ratio can be used to compare the risk-adjusted performance of different portfolios. It is especially useful for portfolios that have a high probability of generating negative returns, as it only takes into account the downside deviation.
It is also useful for investors who are particularly interested in avoiding large negative returns, as it measures the risk of a portfolio in terms of the potential for downside deviation. This can be useful when comparing different investments, as it allows investors to identify those that have a higher potential for downside deviation, and therefore a higher risk of large negative returns.
However, similar to the Sharpe ratio, it is also important to consider the Sortino ratio in the context of the investor’s risk tolerance and investment goals. Additionally, it is also important to note that the Sortino ratio also does not account for skewness or kurtosis of the return distribution.