What Is Sortino Ratio?

July 27, 2023
10 MIN READ
79 VIEWS
The Sortino ratio varies from the Sharpe ratio in that it only considers the standard deviation of the risk of a negative rather than the total (positive + negative) risk. Since the Sortino ratio only considers a decrease in a portfolio's values from the mean, it is considered to provide a more accurate picture of an investment's performance adjusted for risk because rising volatility is advantageous. The Sortino ratio can help financial analysts, traders, and investment managers assess an investment's earnings for a given chance.

What is the sortino ratio?

The Sortino ratio is a variant of the Sharpe ratio that distinguishes detrimental fluctuation from total general instability by using the property's standard deviation of adverse portfolio returns—downside deviation—rather than the total standard deviation of return on investment. The Sortino ratio takes a commodity's return, subtracts the rate at which risk is eliminated, and then divides the sum by the security's negative deviation.

The concept of the sortino ratio

Sortino ratios are calculated when consumers, primarily shareholders, consider just the risk of a negative rather than the entire risk, incorporating both the positive and negative aspects deviations. As a result, it is seen as a more efficient approach to computing risk-adjusted returns.

This ratio allows them to calculate the extra earnings they might anticipate from a portfolio for each component of negative deviation, which deals with the predicted loss caused by shifts in the market.

Traders in mutual fund investments and other financial tools are more concerned about negative volatility because an upward variation will only benefit them. As a result, assessing the risk of a negative becomes essential to determining total market instability.

This ratio allows traders to evaluate excess gains, especially when considering each unit of risk of a negative This provides them with a more accurate and clear view of the potential rewards from a given investment. As a consequence, people have the opportunity to make informed and intelligent judgments.

Despite the projected negative fluctuation, an elevated Sortino ratio suggests superior excess returns. Its main constraint is that unfavorable instability occurrences must be sufficient to compute a statistically meaningful negative deviation.

The Sortino ratio is an enhancement of the Sharpe ratio, another statistic that assists individuals in determining the efficiency of a portfolio after it has been risk-adjusted. The Sortino ratio differentiates itself by distinguishing between positive and downside risks. It delivers a correct rate of return given the possibility of negative impact, whereas the Sharpe ratio evaluates both upward and negative risks equally.

Sortino ratio computation

You must first determine the Sortino Ratio's three primary components: investment return, objective return, and risk of a negative

Determining the sortino ratio elements

·       Investment/ portfolio return: This is the true return a financial portfolio earns over a certain period.

·       Target/ objective return: This is the trader's lowest / minimum acceptable return (MAR). It is used to assess the profitability of the portfolio.

·       The risk of a negative is the downward deviation that gauges the fluctuation of profits below an objective return. It accounts for negative returns or results that fall below the aim.

Sortino ratio formula and computation stages

The sortino ratio is determined by applying the formula below:

Sortino ratio = (Portfolio return – Target return) / Downside risk

To compute the Sortino Ratio, follow these steps:

i.     Calculate the portfolio return and the goal return.

ii.    Determine the downside deviation.

iii.   Enter the data into the calculation to find the Sortino Ratio.

Interpreting the sortino ratio

Comprehending the worth of the sortino ratio is critical for analyzing investment efficacy and comparing alternative portfolio strategies.

·       Portfolio efficacy assessment

A more substantial sortino ratio suggests more effective risk-adjusted performance since it indicates that the holdings produce greater returns than the risk of a negative.

A lesser sortino ratio, on the other hand, indicates poor risk-adjusted performance. A beneficial sortino ratio shows that the financial commitment surpasses the set return, while an adverse ratio suggests that the investment is underperforming.

·       Contrasting various investment options

When evaluating different assets with varied risk profiles, the sortino ratio comes in handy. By concentrating on negative risk, shareholders may assess assets more fairly, identifying those that provide better returns for a given degree of downside risk.

Recognizing the constraints

Although the sortino ratio gives useful information, it is vital to understand its limits. It is aware of the goal return chosen, implying that the only important risk for investors is the downside risk.

Furthermore, because it does not consider the individual allocation of returns, it is less trustworthy for assets with irregular return dispersion.

Uses of the sortino ratio 

The Sortino Ratio may be used in various investment applications, such as managing a portfolio, evaluating risks, and efficiency comparison.

    i. Portfolio administration

Investment professionals may use The sortino ratio to improve their portfolios by picking assets that generate greater returns for a given downside risk.

This can aid in developing a more effective strategy that manages risk and reward, eventually fulfilling the shareholder's objectives and risk tolerance.

   ii. Risk evaluation

The sortino ratio may calculate a stock's negative impact, enabling traders to make more knowledgeable choices regarding risk exposure.

Traders can pick assets less likely to miss the target return by concentrating on the negative aspect deviation.

   iii. Performance evaluation

Investment professionals can use The sortino ratio to compare efficiency to other companies or market indexes.

Compared to a standard, an excellent sortino ratio shows that the administrator produces better risk-adjusted returns, resulting in a more appealing alternative for traders.

Making real-world financial choices using the sortino ratio

The sortino ratio can analyze the risk-adjusted efficacy of different investment alternatives in real-world investing decisions. A sortino administrator can use the portfolio ratio to assess two mutual funds with comparable returns but differing adverse consequences. The management might obtain superior risk-adjusted returns for their customers by picking the fund with the more substantial sortino ratio. It is critical to recognize that the sortino ratio should be used in conjunction with other performance and risk indicators, not in place of them. Using the Sortino Ratio alone may result in an inaccurate analysis of an investment's return and risk characteristics.

The benefits and drawbacks of the sortino ratio

Benefits of the sortino ratio

A sortino ratio is useful for traders and portfolio directors to analyze the return on investment compared to its negative risk since it distinguishes between beneficial and detrimental volatility.

The efficacy of a financial commitment should be assessed by its returns to the degree of risk assumed to attain those returns.

Because upside volatility is advantageous to investors, it should not be incorporated in risk calculations; only unfavorable fluctuation should be considered.

The sortino ratio reduces an investment's returns based on its amount of poor risk to one figure. Investors may then use it to compare the performance of various investment alternatives or fund managers.

The downfalls sortino ratio

The sortino ratio, like other proportions, cannot tell you anything – it is merely a tool.

Furthermore, the ratio is merely as effective as its inputs. Fund managers can cherry-pick details, leading to sortino that are erroneous at best and deliberately deceptive at worst. Use caution when utilizing the sortino ratio (or other ratios) without regard to a significant period and in association with different appraisal methodologies. The sortino ratio cannot be your only investing decision-making tool.

Important considerations

Although the sortino ratio is a useful tool for evaluating assets, there are a few factors to consider. The first is the timetable. It would be beneficial to evaluate investments made over many years, or at least those made over a full business cycle.

As a result, you can account for beneficial and detrimental stock returns. It would not be a genuine depiction of a financial commitment if you only recorded favorable stock returns. The financial stability of the assets is the second element. A portfolio may appear to be less hazardous. However, this may be due to the actual assets being inactive.

For instance, the pricing of holdings in privately held enterprises seldom fluctuates, making them stagnant. If they are included in the sortino ratio, the risk-adjusted returns will appear positive, but they are not.

Modifications and approaches to the sortino ratio

The sortino ratio has numerous modifications and variants that can give additional information about a portfolio's risk-adjusted efficacy.

   i. Sortino ratio modified

The Adjusted Sortino Ratio changes the conventional sortino ratio by including the portfolio's skewness and kurtosis, resulting in a more realistic estimate of downside risk for non-normal return distribution assets.

   ii. The omega ratio

The omega ratio is an alternative risk-adjusted gauge of achievement that calculates the ratio of profits to losses compared to an ideal return to account for the positive and negative aspects possibilities of investment.

This ratio improves understanding of a financial commitment's likelihood and return profile.

   iii. The kappa ratio

The Kappa Ratio is a risk-adjusted performance indicator considering a stock's negative risk and higher-order variables like skewness and kurtosis. This is especially helpful when studying assets with asymmetric return patterns.

Sharpe ratio

Sharpe ratio concept states that analyzing an investment portfolio's risk-adjusted return. As a result, it does not provide precise information about the fund's performance. However, a diversified portfolio of funds with little to no link reduces absolute risk, raising the Sharpe index.

The Sharpe ratio calculates standard deviation, which assumes a uniform distribution of returns. As a result, it may not be an appropriate indicator of achievement for variable return distributions with skewness less than or larger than zero. Furthermore, because standard deviation considers positive and negative variation from the mean return, it is an imprecise estimate of downside risk.

The ratio can be used to determine how much excess past returns were accompanied by excess volatility. While excess returns are calculated in relation to an investment standard, the standard deviation method calculates instability based on the variation of yields from their mean.

The beneficial effects of the ratio are based on the idea that the history of comparative risk-adjusted returns has some predictive value.

Please remember that a high Sharpe index provides a higher investment return than the risk, indicating a superior investment. It focuses on return optimization and fluctuation reduction and analyzing the risk-free rate.

The sortino ratio, in comparison to the Sharpe ratio

Given the aim they serve, the sortino and Sharpe ratio formulas are almost identical in almost every way. Both of these ratios assist investors in determining how an investment portfolio or stock is likely to operate despite market swings. Consequently, they concentrate on volatility and extract appropriate conclusions, whether risk assessment or additional profits.

The Sharpe ratio calculates returns based on overall market volatility, including positive and negative risks. The sortino ratio, on the contrary, exclusively considers the negative risks when calculating additional returns.

Traders prefer sortino ratios since adverse effects are a key worry. Individual traders' targets, goals, and convenience will influence their decision.

What exactly is the sortino ratio in mutual funds?

It is an approach to statistics used to estimate investment returns for a given amount of risk. Investors and economists use this ratio to forecast how a portfolio will perform. As an outcome, they find it simpler to make decisions.

What is an appropriate sortino ratio?

A ratio of 1 to 2 is considered optimum. However, the ratio may approach 3 in certain cases, and in some cases, investors may be content with numbers somewhat less than 1. Furthermore, a negative ratio may be obtained, implying no returns for the risks incurred.

Conclusion

Essentially, the Sortino ratio is a statistical instrument that may be used to assess the efficacy of investment in terms of negative deviation. This ratio fails to account for portfolio instability. It aids in conveying a realistic picture of the potential risks associated with an asset or fund. In simple terms, this ratio aids in determining the risk-adjusted returns of a specific investing plan.

The Sortino ratio is an appropriate analytical tool for retailers since they are primarily concerned with the downside risks of investments. It addresses the negative deviation of a stock portfolio and its earnings, providing a more accurate picture of the portfolio's outcome after possible risks are considered.