If you have tipped your toe into the world of investment, you might have come across the Sortino Ratio. It can be used as a way to compare the risk-adjusted performance of programs. As a small business owner, it can be useful to understand this investment concept. This is why we've compiled a short guide to what the Sortino ratio is, its formula, and when to use it.
What is the Sortino Ratio?
The Sortino Ratio is a variation of the Sharpe Ratio. It measures the risk-adjusted returns of investment or strategy. As opposed to the Sharpe Ratio, it considers only those returns falling below a user-specified target or required rate of return (i.e. the downside deviation). It only looks at the downward deviation and therefore does not take into account the total volatility of an investment.
The Sortino Ratio is the newer method of calculating risk-adjusted returns and is often considered a more valuable tool, as investors are mostly interested in the downside risk only. It gives a more accurate measure of poorer-performing investment potential.
Sortino Ratio Formula
The formula for the Sortino Ratio is as follows: Sortino ratio = (R) - Rf /SD.
- R = Actual or expected return of e.g., investment
- Rf = Risk-free rate of return
- SD = Standard deviation of the Negative Asset Return
When interpreting the calculated Sortino Ratio of an investment strategy, it is important to know that the higher the Sortino Ratio, the better. A higher Sortino ratio means a higher earn for each unit of bad risk it takes on.
When to use the Sortino Ratio?
As the Sortino Ratio is used to identify a portfolio's risk-adjusted returns relative to an investment target, it is a useful instrument for deciding between two investment strategies/ options or evaluating the risks of one option. It lets investors focus on what they should worry about - the downside volatility of a portfolio.
Sharpe Ratio vs Sortino Ratio
While both Ratios are in their essence risk-adjusted evaluations of return on investment, the Sharpe ratio is used to determine how well an investment is performing in comparison to a risk-free investment. The Sortino Ration, on the other hand, looks at an investment's risk-adjusted return, however, only taking into account its downside deviation.
This is why the Sortino Ratio provides is a great tool for evaluating the performance of high volatility assets, such as shares. The Sharpe Ration, on the other hand, is more suitable in evaluating the performance of low volatility assets, such as bonds.
What Is A Good Sortino Ratio?
Overall, the higher the Sortino Ratio is, the better. This simply means that there is a high reward or the risks taken with the investment. If the Sortino Ratio is too low, the risks taken may not pay off. In general, the longer the time span you’re measuring the risk for, the more robust your Sortino ratio will be.
According to the Corporate Finance Insitute, a provider of online financial analyst certification programs, a Sortino ratio of 2 and above is considered good.
If you are comparing two potential investments using the Sortino Ratio, always go for the investment with the higher Ratio.
- What does a negative sortino ratio mean?
A negative Sortino Ratio suggests that the potential investor may not be rewarded for the risk taken with the investment. According to the Corporate Finance Insitute, a provider of online financial analyst certification programs, a Sortino ratio of 2 and above is considered good.
- How do I calculate the sortino ratio from monthly returns?
You can calculate the Sortino ratio by taking the difference between portfolio return and the risk-free rate and dividing it by the standard deviation of the negative returns. The formula is as follows:
- What is the Sharpe Ratio formula?
The formula for the Sharpe Ratio is as follows: Sharpe Ratio = RP - RF / Standard deviation of excess returns. "RP" stands for "Return of Portfolio" and "RF" stands for "Risk-free rate". The Sharpe Ratio can be a helpful tool in evaluating the performance of low volatility assets, such as bonds.