Sortino Ratio
AdvancedThe Sortino ratio measures an investment's return above a target or risk-free rate for each unit of downside risk, counting only volatility from returns that fall below the target.
The Sharpe ratio uses total volatility, treating large gains and large losses as equally risky. Most investors, however, only worry about losses. The Sortino ratio, named after Frank Sortino, focuses on harmful volatility.
It is calculated by subtracting a target return, often the risk-free rate, from the investment's return and dividing by the downside deviation, a measure of how much returns fall below the target.
For example, a fund with an annual return of 10%, a target rate of 3% and a downside deviation of 8% has a Sortino ratio of about 0.88.
The Sortino ratio is especially useful for comparing investments with uneven return patterns, such as strategies that produce occasional large gains. Two funds with the same Sharpe ratio can have different Sortino ratios if one has more of its volatility on the upside. Like other ratios based on past returns, it depends on the period measured and may not predict future performance.
For worked examples and full lessons, visit notesbysara.org.