Sortino ratio is a statistical tool that helps measure an investment’s performance during a downward deviation. It depicts the realistic downside risks that a stock or fund is accompanied by. All investors are majorly concerned about the downside of the market. Here’s where the Sortino ratio comes handy. It concentrates on the negative deviation of a portfolio’s returns and presents a better idea about the investment’s performance after adjusting the risks involved.
But let’s first look at the significance of sortino ratio!
Sortino ratio can help determine an investment portfolio’s performance. The higher the Sortino ratio, the better the expected performance of an investment.
The absolute risk (in an investment or portfolio) is the combination of both – upside and downside risk deviations. Now, the Sortino ratio only accounts for the downside risk and does not consider the entire risk involved. It gives you a realistic idea about the losses you might incur during a downside.
Furthermore, the Sortino ratio may also help you differentiate investments with varying returns and risk profiles.
To calculate Sortino Ratio, you must know the probable returns on your investment in a particular scheme. You must also be aware of the rate of returns on the investment without the risks involved, along with the downside deviation.
You can use the Sortino ratio formula given below for calculations:
Sortino ratio= (Expected returns(Rp) – Risk-free rate (rf))/Downside risk standard deviation
The computation of Sortino ratio is based on the formula mentioned above. The difference between the aggregated gains of an investment portfolio and the risk-free rate return is divided by the standard deviation of negative earnings.
The Sortino ratio is very similar to the Sharpe ratio. There is not a very significant difference between the two. The Sharpe ratio uses the total volatility (upside and downside), while the Sortino ratio uses only the downside.
You can also use an online Sortino ratio calculator as an alternative.
Suppose there are two investment schemes. We will name them ‘P’ and ‘Q’, for instance. Scheme P and Q have the following particulars:
|Particulars||Scheme P||Scheme Q|
|Rate of a risk-free deposit||12%||15%|
From the details given above, we can calculate the Sortino ratio.
Sortino ratio for Scheme P= (20-12)/8=1
Sortino ratio for Scheme Q=(30-15)/18=0.83
We know that the higher the Sortino ratio, the better the investment, as the gains are higher. Thus, Scheme P is better than Scheme Q. Do you observe how the ratio helps make better investment decisions?
Sortino ratio employs downward deviation, so it can help investors make well-analysed decisions. Additionally, investors can use the Sortino ratio to assess the performance of highly volatile assets, like shares.
Similar to the Sharpe ratio, a higher Sortino ratio is better. A rational investor would prefer an investment with a higher Sortino ratio when concerning two similar investments.
For fund and portfolio managers, it’s an effective tool that allows them to measure the performance of funds/stocks. Since it only accounts for downward variation and ignores all positive variances, it offers a more accurate picture of returns. The analysis makes more sense because the downside risks are what investors should be concerned about.
By definition, the Sortino ratio is an improvisation of the Sharpe ratio.
While the Sharpe ratio considers the absolute risk of an investment or project, the Sortino ratio does not. The two are also different when it comes to their usage. The Sortino ratio is used to assess the performance of highly volatile investment portfolios. In contrast, the Sharpe ratio is used when you want to assess the performance of less volatile investments.
The two also differ in the method of their computation. The Sortino ratio is calculated by subtracting the total earnings from the risk-free return rate and dividing the value by the standard deviation (of the negative earnings). On the other hand, the Sharpe ratio is calculated by first subtracting the rate of risk-free earnings from anticipated individual returns. The obtained value is then divided by the standard deviation of the investment portfolio.
To sum up, Sortino ratio is a highly effective statistical performance tool that can easily help you identify suitable investment opportunities. It depicts how the downside risks affect your portfolio and whether or not the particular investment is worth making. However, the ratio has its limitations, and it is best to use other risk-assessing statistical tools.
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Ans: The ideal value of the Sortino ratio must be between 1 and 2. However, there are several instances where the ratio might also reach three and above. Sometimes, investors also consider values slightly below 1. It is important to remember that negative ratios mean no rewards for the risks taken in that investment.
Ans: Sharpe ratio is the excess return of an investment above the risk-free rate in relation to its standard deviation. On the other hand, the Sortino ratio is the excess return of an investment above the risk-free rate in relation to its downside deviation.
Ans: A Sortino ratio of 2 and above is considered idyllic for mutual funds. For mutual funds, the higher the value of the Sortino ratio, the better the returns.
Ans: When you calculate the Sortino ratio with monthly data, you can annualise it by multiplying the result by the square root of 12.
Ans: The risk is computed by finding the difference between the average return rate of an investment and the risk-free rate.
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This article has been prepared on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this article is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party. The article does not warrant the completeness or accuracy of the information and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article.
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