What is the Sortino Ratio?
The Sortino Ratio is a variation of the Sharpe Ratio that differentiates harmful volatility from total overall volatility. While the Sharpe Ratio penalizes both upside and downside volatility equally, the Sortino Ratio only penalizes downside risk—the risk of returns falling below a user-specified target or required rate of return.
This modification allows investors to assess the return per unit of bad risk. It is particularly useful for investors who don't mind volatility when it leads to gains (upside volatility) but are concerned about losses.
The Formula
- Rp (Return of Portfolio): The actual or expected return of the portfolio.
- MAR (Minimum Acceptable Return): The target return required (often the risk-free rate or 0).
- σd (Downside Deviation): The standard deviation of negative asset returns (returns below the MAR).
How to Interpret the Sortino Ratio
Just like the Sharpe Ratio, a higher Sortino Ratio is better. It indicates that the investment is generating more return for every unit of bad risk taken.
- < 0 (Poor): The investment is not even meeting the minimum acceptable return.
- 0 – 1.0 (Sub-optimal): The investment is generating positive returns, but arguably not enough to justify the potential downside losses.
- 1.0 – 2.0 (Good): A healthy ratio indicating the investment manages downside risk well while providing solid returns.
- > 2.0 (Excellent): Indicates superior performance where the investment experiences very little bad volatility relative to its returns.
Sortino Ratio vs. Sharpe Ratio
The key difference lies in how they treat risk:
- Sharpe Ratio: Uses Standard Deviation, which treats all volatility (both up and down) as risk. This can unfairly penalize strategies with high positive volatility.
- Sortino Ratio: Uses Downside Deviation, only penalizing volatility that results in losses (or returns below the target). This gives a more accurate picture for strategies with asymmetric return profiles.