Sortino Ratio

The Sortino Ratio is a financial measure used to evaluate the risk-adjusted return of an investment or portfolio. It is a variation of the Sharpe Ratio, developed by William F. Sharpe.

The Sortino Ratio takes into account not only the expected returns of an investment or portfolio but also the downside risk, specifically the risk of returns falling below a target or minimum acceptable return. It focuses on measuring the downside volatility or risk rather than overall volatility.

To calculate the Sortino Ratio, the difference between the annualized return and the target return is divided by the downside deviation. The downside deviation is a measure of the volatility of returns below the target return, excluding the positive returns.

The Sortino Ratio provides a more accurate assessment of risk-adjusted returns by considering only the downside risk. It is particularly useful for investors or portfolio managers who are more concerned about protecting against losses or downside risk than capturing overall volatility.

A higher Sortino Ratio indicates a better risk-adjusted return, as it implies that the investment or portfolio has achieved the target return with less downside risk. Conversely, a lower Sortino Ratio suggests a higher risk or a lower return relative to the downside risk.

The Sortino Ratio helps investors and portfolio managers make better-informed decisions by focusing on downside risk. It allows them to evaluate investments or portfolios based on their ability to generate returns while minimizing the risk of falling below a certain threshold.

However, it’s important to note that the Sortino Ratio has its limitations. It relies on historical data and assumes that past performance is indicative of future results. Additionally, it does not consider the potential for extreme losses or tail risks.

In summary, the Sortino Ratio is a financial measure that evaluates the risk-adjusted return of an investment or portfolio by focusing on downside risk. It provides a more accurate assessment of risk by considering only the volatility of returns below a target or minimum acceptable return. The higher the Sortino Ratio, the better the risk-adjusted return.