Sortino Ratio – Overview, How To Calculate, When To Use

What is the Sortino Ratio and how can it be used?

The Sortino ratio, a risk-adjustment measure that determines the additional return for each unit with downside risk, is called risk-adjustment. The Sortino ratio is calculated by first finding the difference in an investment’s average rate of return and the risk free rate. The standard deviation of negative returns is then added to the result. A high Sortino ratio, which indicates that investors will earn more for every unit of downside risk, is preferable.

Understanding the Sortino Ratio

You should not focus on the rate of return if you are looking to invest. It is better to consider the risk associated with investing. Risk is the possibility that an asset or security’s financial performance may differ from what is expected.

A downside risk can be defined as a loss of your investment. A potential financial gain, on the other hand, is called an upside risk.

Many performance metrics do not account for variation in investment risk. They simply calculate the return rates. The Sortino ratio is different. This indicator measures changes in the risk-free interest rate, which allows investors to make better decisions.

The Sortino Ratio is an improvement on the Sharpe rate. This metric helps investors gauge the performance of investments after they have been adjusted for risk. The Sortino ratio is unique because it recognizes the difference between upside risk and downside risks. It provides an accurate rate for return given the probability of downside risk. The Sharpe ratio, however, treats both downside and upside risks equally.

Calculating the Sortino Ratio

The formula to calculate the Sortino Ratio is:

Sortino Ratio = Average Realized Return – Expected Return. / Downside Risk Deviation

The average realized returns refers to the total weighted return from all investments in an individual’s portfolio. The expected rate of return (or required return rate) is the return on long term government securities.

We will use the following example:

S = (R – T) / DR

Where:

• S – Sortino ratio
• R Average realized return
• T Required rate of return
• DR – Target downside deviation

Let’s say we are given the following annual returns rates: 4% to 10%, 15% to 20%, 20% to 5%, 2% to 6%, 8% and 23% respectively.

1. 8% is the annual average return rate. This equals (4% + 10% + 15 + 20% + -55% + -22% + +6% + 8 + 23% + 13%)

2. Let’s assume that 7% is the required return rate. The additional return would then be 1% (8%-7%). In our equation, the numerator will be the value.

3. Next, calculate the standard deviation for downward risks (those that have a negative value). As long as they have zero deviations, we will not accept positive returns.

Take the positive and negative deviations and then calculate their average.

(-5%)2 = 0.0025

(-2%)2 = 0.0004

(-6%)2 = 0.0036

Average = (0.0025 +0.0004 + 0.0336) / 10 = HTML0.00065

5. Find the standard deviation using the square root.

0.00065 = 0.0255

It allows us to:

R = 8%

T = 7%

DR = 0.02255

6. Next, calculate the Sortino Ratio as shown below:

S = (R-T) /

R – T = 0.01 or 1%

S = 0.01/0.0255 = 0.392

A Sortino ratio of 2 or more is ideal. This investment’s 0.392 percent rate is unacceptable.

When should you use the Sortino Ratio?

This is superior to the Sharpe ratio because it only considers the downside variability of risk. This analysis is useful because it allows investors to evaluate downside risks. That’s what investors should be concerned about. There are no upward risks, which is when an investment produces an unexpected financial benefit.

The Sharpe ratio, by contrast, treats downside and upside risks equally. This means that gains-producing investments are penalized.

The ratio is recommended for assessing the performance of high-volatility assets such as shares. The Sharpe ratio, on the other hand, is better suited for analysing low volatility assets such as bonds.

Important Considerations

This can be a great metric to compare investments. However, there are some things you need to consider. The timeframe is one. You might consider investments over many years, or even those made in a complete business cycle.

This allows you to account both positive and negative stock return. It would be misleading to only record positive stock returns as it is not a true reflection on an investment.

The liquidity of the assets is the second factor. Although a portfolio may seem less risky than others, it could be because the assets are not liquid.

Investments in private-owned companies are, for example, illiquid because their prices rarely change. They will appear to be favorable if they are incorporated into the Sortino ratio. However, they are not.

Take a bow

Although the Sharpe ratio is nearly identical to the Sortino ratio, it has one difference. The Sharpe ratio calculates risk-adjustments for investments that have both positive and negative returns.

However, examines risk-adjusted return but only the downside risks. The Sortino ratio can be seen as a better indicator for risk-adjusted return because it does not consider upside risks which are not a concern for investors.