Definition
The Sortino Ratio is a statistical tool used to measure the risk-adjusted return of an investment or portfolio. It is similar to the Sharpe Ratio, but it only considers the downside risk, or negative volatility, instead of the total volatility. The higher the Sortino Ratio, the superior is the risk-adjusted return of an investment.
Key Takeaways
- The Sortino Ratio is a statistical tool that measures the performance of an investment relative to the downward deviation. It’s an adjustment of the Sharpe Ratio, but specifically isolates harmful volatility, as it considers only the negative volatility of an investment’s returns, not total volatility.
- It is a useful way to evaluate an investment’s return for a given level of bad risk. The Sortino Ratio is beneficial for investors because it considers the potential downside, or negative returns, which can vary for different investments. Higher Sortino Ratios illustrate less probability of large losses.
- The ratio is computed by deducting the risk-free return from the portfolio’s return, dividing the result by the standard deviation of the portfolio’s negative returns. But it may not be a reliable estimate for the probability of large losses if the negative asset returns aren’t normally distributed or if the portfolio has not been held for a long time.
Importance
The Sortino Ratio is a significant financial metric because it provides a means for investors and analysts to quantify the risk-adjusted return of an investment, portfolio, or strategy.
Unlike the Sharpe ratio, the Sortino ratio takes into account only harmful volatility – that is, the risk of a decrease in value, instead of overall volatility.
This distinction is crucial because it reflects the fact that most investors are primarily concerned with the potential for negative returns.
Therefore, a higher Sortino ratio implies that the investment or portfolio has a better risk-adjusted performance or, in other words, there is less likelihood of a negative deviation from the mean return.
This allows investors to make more informed investment decisions.
Explanation
The Sortino Ratio is fundamentally designed to measure the risk-adjusted return of an investment asset, portfolio, or strategy. The primary purpose of this financial ratio is to provide a more targeted evaluation of risk-to-reward performance than other conceptual models, focusing chiefly on downside volatility rather than total volatility.
It distinguishes harmful volatility from total volatility, enabling the analysts, traders, and investors to differentiate between favourable and adverse volatility contained in the investment’s returns. Moreover, the Sortino Ratio is principally used to quantify how well an investment is performing in comparison to the risk of negative returns.
It enables investors to consider not just the returns on an investment, but the potential for loss that comes with achieving those returns. Essentially, a higher Sortino ratio indicates a less risky investment when compared to investments with lower Sortino ratios.
Thus, the prime usage of the Sortino ratio is to assist in decision-making by taking account of the likelihood and severity of potential losses.
Examples of Sortino Ratio
Investment Management: An investment management firm uses the Sortino ratio to evaluate the performance of different portfolios they manage. They have two primary funds – Fund A and Fund B. Fund A has a Sortino ratio of5, and Fund B has a Sortino ratio of
Using the Sortino ratio, the firm can suggest that Fund A is potentially a better investment for clients with low tolerance for downside risk since it shows a better return for the level of bad risk it has taken.Personal Investing: An individual investor is looking to invest in a mutual fund. They’re comparing two funds – one focused on tech stocks (Tech Fund) and another investing across various sectors (Diversified Fund). The Tech Fund has a Sortino ratio of
2 while the Diversified Fund has a Sortino ratio ofEven though the Tech Fund may have a higher total return, the Diversified Fund has a better Sortino ratio, indicating its returns are more stable and it carries less downside risk. This helps the investor to make an informed decision.
Risk Analysis in Insurance Companies: An insurance firm uses the Sortino ratio to assess the financial risk associated with their different insurance products. One of their life insurance policies has higher premiums but promises guaranteed returns and has a Sortino ratio of 2, whereas another one has lower premiums with variable returns and a Sortino ratio ofDespite higher premiums, the life insurance policy with a higher Sortino ratio represents better downside risk management, helping the firm to showcase it as a more suitable option for risk-averse customers.
FAQs about Sortino Ratio
1. What is Sortino Ratio?
The Sortino Ratio is a statistical tool used to measure the performance of an investment or a portfolio, adjusted for downward price volatility. It is similar to the Sharpe Ratio but focuses on negative variance, treating only negative price movements as risk.
2. How is Sortino Ratio calculated?
The Sortino Ratio is calculated by subtracting the risk-free rate from the portfolio’s return, and then dividing by the downside deviation. The downside deviation is the squared root of downside variance which is the square of negative portfolio returns.
3. What does a high Sortino Ratio mean?
A high Sortino Ratio indicates that the investment or fund has a high return for a given level of bad risk, which is the risk of negative returns. A high ratio could be due to high returns, low negative volatility, or both.
4. How does Sortino Ratio differ from Sharpe Ratio?
While both Sortino and Sharpe Ratio measure risk-adjusted performance, they treat risk differently. Sharpe Ratio considers all volatility as risk, while the Sortino Ratio regards only the downside, or negative price volatility, as risk.
5. Can the Sortino Ratio be negative?
Yes, the Sortino Ratio can be negative. Negative Sortino Ratio indicates that the investment’s negative returns are greater than the returns it yields above the risk-free rate.
Related Entrepreneurship Terms
- Downside Risk
- Standard Deviation
- Target Return or Desired Return
- Risk-adjusted Performance
- Portfolio Management
Sources for More Information
- Investopedia: Comprehensive resource that explains and educates on a wide range of financial and investment concepts, including the Sortino Ratio.
- Morningstar: A well-established investment research firm that covers many topics related to finance and investment, including performance metrics like the Sortino Ratio.
- Portfolio Visualizer: Provides online portfolio tools for both individual investors and finance professionals, including detailed analysis using metrics such as the Sortino Ratio.
- CFA Institute: A globally recognized association for investment professionals. Offers a vast array of educational resources and professional certifications, which often cover topics like the Sortino Ratio.
