Sortino Ratio Formula, Calculation & Example

What is the Sortino Ratio?

The Sortino Ratio is a risk-adjusted return metric that is used by investors and traders to assess an investment’s performance relative to its downside risk. Unlike the Sharpe Ratio, which penalizes both upside and downside volatility, the Sortino Ratio focuses specifically on downside risk, making it a more accurate measure of the risk-adjusted return for risk-averse investors.

Key Takeaway:

• The Sortino Ratio emphasizes downside volatility, which is the harmful part of price fluctuations.
• It helps investors evaluate whether an investment’s returns justify its risks, especially focusing on avoiding losses.

How to Calculate the Sortino Ratio

The formula to calculate the Sortino Ratio is straightforward but powerful. It involves comparing the investment’s actual return to a target return, usually the risk-free rate, and dividing that by the downside deviation.

Sortino Ratio Formula:

Sortino Ratio = (Rp – T) / DD

Where:

• Rp = Actual return of the portfolio
• T = Target or required rate of return (typically the risk-free rate)
• DD = Downside deviation (standard deviation of negative returns)

Example of the Sortino Ratio Formula

Let’s consider an investment scenario where:

• The annual return is 15%
• The risk-free rate is 5%
• The downside deviation is 10%

Using the Sortino Ratio formula, we calculate:
Sortino Ratio = (15% – 5%) / 10% = 1.0

This means that for every unit of downside risk, the investor has earned 1% in excess return.

What is a Good Sortino Ratio?

Generally, a Sortino Ratio greater than 1.0 is seen as a positive sign, indicating that the investment’s returns are outperforming the downside risks. Here’s a general guide to interpreting the Sortino Ratio:

• < 1.0: Below average risk-adjusted return, indicating high downside risk
• 1.0 – 2.0: Acceptable to good risk-adjusted return
• 2.0: Excellent risk-adjusted return, showing strong performance relative to downside risk

A Sortino Ratio above 2.0 typically indicates outstanding risk-adjusted returns.

Sortino Ratio Example: A Real-World Case

Let’s say you have a portfolio with:

• An annual return of 12%
• A target return of 4%
• A downside deviation of 8%

The Sortino Ratio would be:
Sortino Ratio = (12% – 4%) / 8% = 1.0

This tells you that the portfolio is achieving reasonable returns for the amount of downside risk involved.

Advantages and Limitations of the Sortino Ratio

Advantages:

• Focus on Downside Risk: The Sortino Ratio penalizes only the negative volatility (downside risk), making it a more accurate measure for risk-averse investors compared to the Sharpe Ratio.
• Better Risk Assessment: It helps in better understanding how much return is earned for each unit of downside risk.
• Improved Accuracy for Non-Normal Distributions: For assets with skewed returns, the Sortino Ratio provides a clearer picture of risk-adjusted performance.

Limitations:

• Historical Data Dependency: The ratio depends on historical data, and past performance might not always predict future returns.
• Subjectivity in Target Return: The choice of target return can affect the outcome, making it subjective to the investor’s expectations.
• Limited Use for Speculative Assets: For highly volatile or speculative assets, the Sortino Ratio might not fully capture the risks due to large upside volatility.

Conclusion

Understanding the Sortino Ratio is essential for any trader or investor who seeks to optimize their risk-adjusted returns. By focusing on downside risk, the Sortino Ratio provides a more accurate assessment of an investment’s performance, helping you make informed decisions while minimizing potential losses. Whether you’re assessing stocks, bonds, or forex, this ratio is a powerful tool for evaluating risk versus return.

At Ultima Markets, we provide a secure, and transparent trading environment to support traders looking to optimize their strategies. By leveraging tools like the Sortino Ratio, we empower you to make smarter, data-driven decisions. Our platform, which is committed to sustainability and innovation, allows you to trade with confidence, knowing that your investments are backed by strong regulatory oversight and cutting-edge technology.