What is the Difference Between the Sharpe Ratio and the Sortino Ratio

When assessing the risk-adjusted performance of portfolios, various metrics are used. Sharpe ratio and Sortino ratio are two examples of commonly used metrics. These metrics offer insight into the return on investment in relation to its risk, but their methodologies and goals differ. 

Understanding the distinction between the Sharpe and Sortino ratios is crucial for investors who wish to make knowledgeable portfolio decisions. In this article, we will explore these ratios and their key differences.

What is the Sharpe Ratio?

The Sharpe ratio compares the performance of a risky investment vehicle or strategy to that of an investment that is free of risk. So it can be government-issued bonds, by factoring in the additional risk associated with holding the asset. This is determined by dividing the average period's excess return over the risk-free rate by the return-generating procedure's standard deviation.

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The risk-free rate refers to the risk-free investment return. The standard deviation is an indicator of the investment's return volatility.

Economist William Sharpe, a Nobel Prize winner, developed Sharpe Ratio. 

Sharpe ratio = (Rp – Rf) / σp 

where:

Rp = portfolio's return 

Rf = risk-free rate of return

σp = portfolio’s excess returns' standard deviation 

What are the Sharpe Ratio's Advantages?

The Sharpe ratio has numerous advantages:

1. The ratio is easy to calculate.
2. It is a commonly employed ratio.
3. Also, it is a reliable indicator of the risk-adjusted return of an investment.
4. It can help to compare the performance of various investments. 
5. Also, it can help to compare the performance of various investment managers.

What are the Sharpe Ratio's Disadvantages?

The Sharpe Ration has disadvantages too. 

1. It does not consider the investor's aims and objectives.
2. It does not account for the risk tolerance of the investor.
3. It does not account for the investment's time horizon. 
4. It does not account for the investment's liquidity.

What is the Sortino Ratio?

The Sortino ratio provides significantly more understanding of the risk related to a particular strategy or asset. The Sharpe ratio evaluates profit, volatility (risk), and the amount you could have earned from a risk-free investment. It aims to address the inherent faults of the Sharpe ratio.

Furthermore, this ratio employs the downside deviation as the denominator rather than the return's standard deviation. 

Sortino Ratio = (Projected annual return – Risk-free rate of return) / Downside deviation

What are the Sortino Ratio's Advantages?

The Sortino ratio has numerous advantages:

1. It takes the investor's aims or intentions into account. 
2. It considers the investor's risk tolerance.
3. It takes into consideration the investment's time horizon. 
4. It can also help to evaluate the performance of various investments. 
5. It can also help contrast the performance of various investment managers.

What are the Sortino Ratio's disadvantages?

The Sortino ratio has numerous drawbacks. 

1. The ratio is more difficult to determine than the Sharpe ratio.
2. It is less popular than the Sharpe ratio. 
3. It does not account for the investment's liquidity. 
4. The investment's taxability is not taken into account.

Sharpe Ratio Vs. Sortino Ratio: Major Difference

The Sharpe ratio calculates returns by considering the total market volatility. Also, it considers both upside and downside risks. In contrast, the Sortino ratio considers only downside risks when evaluating additional returns.

As investors' primary concern is downside risk, they favour Sortino ratios. However, the decision will rely on the particular investor's aims, objectives, and ease.

Final Words

The primary difference between both is that the Sortino ratio only accounts for downside risk. In contrast, the Sharpe Ratio accounts for both upside and downside risk. The selection between the Sharpe ratio and the Sortino ratio is the personal choice and investment strategy of the investor. The Sharpe ratio could be more appropriate for investors who have concerns about both upside and downside risks. Yet, the Sortino ratio might prove more helpful for investors who are more inclined to be concerned with avoiding downside risk.

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