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What is a Sortino Ratio?
What’s important to know about it?
In this article, I will break down the meaning of Sortino Ratio so you know all there is to know about it!
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What Is Sortino Ratio
The Sortino Ratio allows investors to assess an investment’s return for a given level of bad risk.
The Sortino Ratio uses an asset’s standard deviation of negative portfolio returns to assess the bad volatility of an investment compared to the total overall volatility.
This financial ratio uses the downside deviation as its risk measure as investors and portfolio managers are more concerned with downside volatility than upside volatility.
The Sortino Ratio is essentially a variation of the Sharpe Ratio where you are only considering negative volatility rather than total volatility.
Investors, analysts, and portfolio managers tend to prefer higher Sortino ratios as they know that for each unit of additional downside risk, they get a higher return.
Keep reading as I will further break down the Sortino Ration and tell you why it’s important and how to calculate it.
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Why Sortino Ratio Is Important
The Sortino Ratio is an important ratio if you’re looking to assess the overall return of an investment along with its associated level of risk.
When you look at an investment’s rate of return, you get a good idea of the profitability of the investment but you don’t get any meaningful information about the risk you are taking.
Using the Sortino Ratio allows you to see how your investment performance can vary from your expected return.
Since the Sortino Ratio measures the risk of an investment by examining the changes in the risk-free rate, investors and portfolio managers can make better investment decisions.
Also, the Sortino Ratio is considered to be a better version of the Sharpe Ratio as it looks at the downside risk of investment whereas Sharpe Ratio penalizes investments having the potential to generate a positive return.
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How To Calculate The Sortino Ratio
Here is the formula you need to calculate the Sortino Ratio:
Sortino Ratio = (Average Realized Return – Expected Rate of Return) / Downside Risk Deviation
The average realized return is essentially the weighted mean of the investment’s total returns.
The expected rate of return refers to the risk-free return such as those given on long-term government bonds.
For example, to calculate the Sortino Ratio, you’ll need to find your investment’s annual return rates and find the risk-free rate in the market.
You should first take the average return of your investment.
Then you identify the expected rate of return on long-term government bonds.
Then you find the standard deviation of downward risk by taking the square of the downside risk and finding their average.
Then you take the square root for the result.
Finally, you take the figures you calculated and plug them into the Sortino Ratio formula to get the measure.
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When To Use The Sortino Ratio
Since the Sortino Ratio measures the downside risk of an investment, it’s worth using this financial measure to assess investments with higher volatility.
For example, the Sortino Ratio will be suitable to assess the downside risk of stocks.
The Sortino Ratio is only concerned with the downside risk of an investment (it considers investments with upward risk are desirable).
To avoid penalizing investments that generate upward gains, you should use the Sortino Ratio to really get an understanding of an investment’s downside risk.
The Sortino Ratio may not be as suitable for investments with low volatility.
In such cases, you may want to use the Sharpe Ratio instead.
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Sortino Ratio vs Sharpe Ratio
What is the difference between the Sortino Ratio and Sharpe Ratio?
In essence, both the Sortino Ratio and Sharpe Ratio are similar as they are both concerned with the measurement of investment risk.
They both focus on the volatility of the investment and the impact of risk to generate additional returns.
However, the Sortino Ratio is only concerned with an investment’s downside risk whereas the Sharpe Ratio considers both downside and upside risk.
Many investors consider the Sortino Ratio to be an improvement over the Sharpe Ratio as they are more worried about the impact of downside risk on their investment than upward risk.
Since the Sortino Ratio only considers downside risk, investments with positive risk profiles are not penalized.
Typically, the Sortino Ratio is used for investments having higher volatility, and the Sharpe Ratio for investments with lower volatility.
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Sortino Ratio FAQ
What is a good Sortino Ratio?
Just like many other financial ratios, the answer is that it depends.
Many investors consider that a Sortino Ratio of 2 is ideal for investment and below 1 is not acceptable.
However, depending on the investor’s risk tolerance and investment characteristics, an investor may accept a Sortino Ratio going below 1.
What is an example of Sortino Ratio?
Let’s assume Mutual Fund A has a 15% annualized return and an 8% downside deviation and Mutual Fund B has a 10% annualized return and a 6% downside deviation.
If the risk-free rate in the market is 3%, the Sortino Ratio will come out to the following:
- Mutual Fund A: 15% – 3% / 8% = 1.5
- Mutual Fund B: 10% – 3% / 6% = 1.16
How do you interpret the Sortino Ratio?
The Sortino Ratio provides you a measure of how much more return you will get based on additional units of risk.
The higher the Sortino Ratio, the more return you can expect to generate with each additional unit of downside risk.
A negative Sortino Ratio means that the risk-free rate is higher than the investment return.
A Sortino Ratio between 0 and 1 is considered not ideal, 1 is acceptable, 2 is very good, and 3 or higher is considered excellent.
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So there you have it folks!
What is the Sortino Ratio?
In a nutshell, the Sortino Ratio is a financial measure allowing you to determine the additional return for each additional unit of risk.
You can calculate the Sortino Ratio by first calculating the difference between an investment’s average return rate and the risk-free rate.
Then, you take the result and divide it by the standard deviation of negative returns.
The objective is to calculate an investment’s risk-adjusted return.
The higher an investment’s Sortino Ratio, the more you generate returns for each additional unit of risk, which is desirable.
The lower the Sortino Ratio, or negative, it means you are not looking at a viable investment option.
Now that you know what is the Sortino Ratio and how it works, good luck with your research!
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