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Sortino ratio: Definition, formula, and practical examples

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Published Date: 29 Oct 2024Updated Date: 29 Oct 20246 mins readBy MOFSL

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Introduction

When investing, making the right choice is your top priority. However, while comparing investment schemes, you may find it overwhelming to find the "right" one. So then, what is the simplest way? It is to look into the financial metrics that help you gauge the performance of an investment tool. The Sortino ratio is one such metric that focuses on how the investment performs in one of the most challenging circumstances, which is represented through downward deviation. This simple guide takes you through all you need to know about it.

What is the Sortino ratio?

The Sortino ratio is a statistical tool that takes into account the downside risk. This ratio does not consider the volatility of an investment. It is a realistic measure to understand an investment's risk. It goes beyond simply concentrating on the returns due to the volatile nature of stocks. It isolates the "bad" volatility – those returns that fall below a specific target or threshold. This makes it useful if you are primarily concerned about the potential for loss rather than variability in general.

In other words, the Sortino ratio gives you an understanding of the risk-adjusted returns while eliminating the impact of positive volatility. This is often desirable in investments. Also, by focusing on the downside deviation, it becomes an effective tool to compare the performance of high-risk assets.

Formula and calculation of the Sortino ratio

The formula for calculating the Sortino ratio is as follows:

SR = Rp – Rf / σd

Here,

· SR stands for the Sortino ratio

· Rp refers to the expected return

· Rf indicates the risk-free rate of return

· σd represents the downside deviation, a measure of negative volatility.

This formula is helpful to assess how much excess return (return above the risk-free rate) you get for each unit of the downside risk. The higher the Sortino ratio, the better the investment is in terms of achieving risk-adjusted returns without significant downside exposure.

Sortino ratio vs Sharpe ratio

The Sortino ratio is a variation of the Sharpe ratio. In that, it is not entirely similar. Both metrics are used for evaluating portfolio performance, but the methodologies vary:

Sharpe ratio measures total volatility. It considers the upside and downside by dividing the excess return by the total standard deviation of returns.

The sortino ratio, on the other hand, isolates the downside volatility. It is a superior measure for considering the potential losses.

Example of using the Sortino ratio

To understand the real-world application of the sortino ratio, let's say you are comparing two funds: Mutual Fund A and Mutual Fund B. Fund A has an average annual return of 12%, while Fund B has a slightly lower return of 10%. At first glance, Fund A appears more attractive. However, after calculating the Sortino ratio, you will realise Fund B has a higher Sortino ratio due to lower downside risk. In this case, Fund B qualifies as a superior investment after considering the risk of negative returns.

This demonstrates the power of the Sortino ratio in evaluating risk-adjusted returns. It lets you look beyond simple returns and focus on the potential for loss, which is often the most crucial factor in decision-making.

Key considerations for using the Sortino ratio

When you apply the Sortino ratio in a Mutual Fund, it is worth considering these crucial factors :

· Timeframe of analysis

The accuracy of the Sortino ratio increases when you calculate it over a complete market cycle. Short-term evaluations may fail to capture the full range of potential downside risks.

· Downside risk focus

The Sortino ratio is most appropriate when downside risk is your primary concern in an investment. For other low-risk, low-volatility investments like bonds, you can use the Sharpe ratio.

· Asset class

This ratio is especially useful for comparing high-volatility assets like Equities and Derivatives as this allows you to primarily focus on the downside risks.

· Liquidity considerations

Liquid assets may distort the Sortino ratio. This makes them appear less risky than they actually are. You should take this into account when analysing assets like equities.

· Consistency in calculations

When using the Sortino ratio, it is critical to ensure consistency in the inputs. For example, you can use either historical returns or projected returns, but not both. This helps maintain accuracy.

Conclusion

With a valuable metric like the Sortino ratio, you can access the risk-adjusted returns for your portfolio without penalising the positive volatility. It solely focuses on the downside risk to provide you with a clear picture of how much risk an investment poses in relation to its potential for loss. So, if you are managing your portfolio of stocks or want to compare mutual funds, using the Sortino ratio for analysis lets you make more informed, data-driven decisions. Make sure to calculate this ratio for all high-volatility assets in your portfolio to get insights into which investments are truly performing well.