FINANCIAL TOOL
Sortino Ratio
This equation is extremely useful in comparing downside risk of different assets.
When investors talk about volatility, they typically mean the overall movement of an asset.
But we like movement! We invested for upside movement!
So volatility can be a good thing. It’s not only a cost (downside), but also the reward (upside).
The Sortino Ratio attempts to correct a weakness of the Sharpe Ratio, which we examined a couple weeks back.
The question it answers is this:
How much return has an investment generated in excess of the risk-free return, per unit of downside risk?
Sortino Ratio =
(Return of the portfolio) – (Risk-free rate)
Standard deviation of the downside
Downside risk can be measured either as downside deviation from the risk-free rate or downside deviation from the average return of the asset, depending on how strictly you define downside risk.
So how can you use this in real life? Consider this example:
Investment A
Averaged 9% over 5 years
2% standard deviation of the downside
Investment B
Averaged 12% over 5 years
4% standard deviation of the downside
If we say the risk-free rate is 5%, then:
Sortino Ratio
Investment A = 2.00
Investment B = 1.75
From this example, Investment A offers better reward per unit of downside risk than Investment B, even though B resulted in higher absolute return!
If you are a risk-taker, you may still choose to go with B. But if you’re interested in managing risk effectively, you may choose to go with A.
Weaknesses in this method of risk-reward comparison include:
-
- Standard deviation is not the only way to measure risk; it’s just a popular way because it’s easily measured.
- This only measures past numbers which are not indicative of what they will be in the future.
- There are different ways to measure downside standard deviation, so make sure you are comparing apples-to-apples when using this method.
One place to compare Sortino Ratios is Fund Performance (portfoliovisualizer.com). Just type in the ticker symbol for the stock or ETF you want to see, and it will usually include the Sortino Ratio in its statistics.