## What Is the Sortino Ratio?

The Sortino ratio is one of several tools that can be used to measure the risk-adjusted return of an investment, but the Sortino ratio is unique because it focuses on downside risk.

In other words, it gives investors and portfolio managers a sense of how likely it is that an investment will lose value or fall below a certain threshold. The ratio determines the additional expected returns per unit of downside risk.

The ratio is calculated by dividing an investment’s excess return by its downside deviation.

Pro Tip: For quick and accurate calculations, use a Sortino ratio calculator, streamlining your investment analysis process and allowing for efficient decision-making. More on that later.

Key Takeaways: The Sortino Ratio Calculator

• The Sortino ratio measures risk-adjusted returns by focusing on downside risk, crucial for assessing potential losses against returns;
• Used by investors and portfolio managers, it aids in decision-making by providing insights into investment risk;
• Its focus on downside risk offers a more accurate picture of potential losses, enhancing risk management strategies;
• While valuable, the Sortino ratio has limitations, including reliance on historical data and neglect of upside volatility;
• Despite limitations, it remains a valuable tool when used in conjunction with other metrics for comprehensive investment analysis.

Keep in Mind:

The Sortino ratio focuses solely on downside risk, offering a clearer picture of potential losses compared to returns. While historical data is essential, remember that the Sortino ratio doesn’t predict future performance.

## The Sortino Ratio Formula Explained

The Sortino ratio formula is (Average return – Risk free rate)/Downside deviation

Let’s take a closer look at each of the variables required for a Sortino ratio calculation.

### Average Return

This is an average of an investment’s returns over a period of time. It is calculated by adding together a series of returns and dividing that figure by the number of returns or periods.

For example, if the returns for the last 5 years were 5%, 8%, 11%, 19%, and -1%, the average return would be:

Average return = Sum of returns/No. of returns = (5+8+11+19-1)/5 = 8.4

### Risk-free Rate

Risk-free rate of return is a benchmark against which other returns are measured. It is the rate of return that an investor would expect from an investment that carries zero risk. This variable is a theoretical concept because, in reality, every investment carries a degree of risk.

The yield on a three-month U.S. Treasury bill is used as a proxy for risk-free rate because it is considered an almost risk-free investment.

Short-term government bills of other highly-rated countries, such as Germany, are used by investors whose assets are not primarily in US Dollars.

Risk-free rates fall into two categories: a nominal risk-free rate which does not account for inflation and a real risk-free rate which does incorporate inflation.

For example, the government bond rate at the time of writing is 5.21% and the US inflation rate is 3.35%. Therefore:

Real risk-free rate = (1+ government bond rate)/(1+ inflation rate) = (1+5.21)/(1+3.35)= 1.42%

### Excess Return

The numerator of the Sortino ratio formula represents excess returns. This is a measure of how much the fund has outperformed the benchmark. Excess returns are equal to the difference between actual returns and the risk-free rate of return.

### Downside Deviation

Downside risk is the risk that an investment could lose value. A portfolio or asset’s downside deviation (also called downside volatility) is a measure of downside risk. This metric uses past returns data to estimate the likelihood that returns will fall below the average or minimum expected return in the future.

#### Downside deviation vs standard deviation

Standard deviation is a vital tool in all kinds of statistics, including calculating downside risk. It measures the dispersion of a dataset relative to an average. An investment with a high standard deviation is volatile while an investment with a low standard deviation is stable, with returns staying close to the average.

Downside deviation can be described as the standard deviation of negative asset return. It uses the same formula as standard deviation but only takes into account negative returns or returns that fall below a benchmark.

In the image below, for example, only the figures for 2015, 2020, 2021, and 2022 would be included in a downside risk calculation.

Therefore, it is a measure of downside volatility rather than overall volatility.

### Calculating Downside Deviation

#### 1. Set a benchmark:

The benchmark used for a downside deviation calculation is called the minimum acceptable return (MAR). This could be the average rate of return, zero, or the risk-free rate. For this example, we’ll use the risk-free rate which is currently approximately 5%.

Let’s say you are calculating the downside deviation for a 5-year period and the annual returns are as follows.

• 2023: -5%
• 2022: 9%
• 2021: -3%
• 2020: 8%
• 2019: -2%

Subtract the benchmark from your return values as follows:

• 2023: -5% – 5% = -10%
• 2022: 9% – 5% = 4%
• 2021: -3% – 5% = -8%
• 2020: 8% – 5% = 3%
• 2019: -2% – 5% = -7%

Only the values for 2023, 2021, and 2019 are relevant to your calculation because they are negative.

#### 3. Square the downside deviations and add them together.

-10 squared is 100. -8 squared is 64. -7 squared is 49.100 + 64 + 49 = 213

#### 4. Divide by the total number of periods.

213/5 years = 42.6

#### 5. Calculate the square root of that figure.

The square root of 42.6 is approximately 6.52. Therefore this investment has a downside deviation of about 6%.

## Sortino Ratio Calculator

If you don’t want to do all of the calculations yourself, check out our sortino ratio calculator. All you have to do is collect the accurate data you need and then plug it into the calculator below and hit “Calculate.”

## What Is a Good Sortino Ratio?

When comparing two investments, a higher Sortino ratio represents a better investment because it is an indication of higher returns per unit of risk.

A Sortino ratio of:

• <0 means your investment is losing money
• 0-1 is poor
• >1 is acceptable
• 2-3 is very good
• 3-4 is excellent

## Sortino Ratio Example

Say that you are considering investing some of your business’ cash into mutual funds and you choose 2 frontrunners:

1. Fund A;
2. Fund B.

Now you want to gauge their risk-adjusted return and downside risk so you decide to use the Sortino ratio. Here is the data we need to calculate the ratio for both funds.

 Fund A Fund B Average return 12% 8% Downside deviation 8% 10% Risk-free rate 5% 5%

Sortino ratio for Fund A = (Average return – Risk free rate)/Downside deviation = (12-5)/8 = 0.875

Sortino ratio for Fund B = (8-5)/10 = 0.3

Fund A has a higher Sortino ratio than Fund B.

This suggests there are fewer downside risks associated with the fund. However, the Sortino ratios for both Funds are below 1 which indicates that the risk-adjusted returns are poor, suggesting that neither is a good investment.

With this result, you decide to investigate other top funds until you find one with a much higher Sortino ratio.

## Sortino Ratios in the Real World

The Sortino ratio is used by retail investors, business owners, corporate investors, accountants, traders, portfolio managers, and analysts to:

• Assess the downside risk of an investment
• Compare investments

Of course, no formula can ever predict the performance of an investment but data from investment analytics company AlternativeSoft demonstrates that the Sortino ratio tends to be a good indicator.

They investigated a collection of high-volatility funds and separated them into four buckets.

• Bucket 1 (blue line) funds have a Sortino ratio of 1.18
• Bucket 2 (orange line) funds have a Sortino ratio of 0.55
• Bucket 3 (grey line) funds have a Sortino ratio of 0.49
• Bucket 4 (yellow line) funds have a Sortino ratio of 0.47

In the graph below, you can see that buckets with a higher Sortino ratio performed better than buckets with a lower Sortino ratio.

## Sortino Ratio vs. Sharpe Ratio

Both the Sortino ratio and Sharpe ratio are methods of measuring risk-adjusted return. The Sortino ratio is a variation of the Sharpe ratio and was developed over a decade later.

While the Sortino ratio focuses on downside variability, the Sharpe ratio measures total volatility, including both upside and downside risk.

The numerator for both ratios is the same but the denominator for the Sharpe ratio is the standard deviation of the investment rather than the downside deviation.

The Sharpe ratio is calculated as follows.

Both tools are valuable to investors and portfolio managers but they have slightly different uses.

Generally speaking, the Sortino ratio is better suited to investments with the potential for significant downside risk and is especially useful during market downturns.

The Sharpe ratio, meanwhile, is preferred for low-volatility investments and is sometimes favored for having a more universal formula which makes it easier to compare investments.

Most advanced investors like to use multiple ratios and analytical methods to gauge their investments so make sure to use all of the most powerful tools available to you to make the best, most informed decisions.

Remember: Combining the Sortino ratio with other metrics like the Sharpe ratio provides a comprehensive assessment of investment performance.

## Limitations of the Sortino Ratio

The Sortino ratio is an effective tool for your investment analysis toolkit but it does have limitations.

1. The Sortino ratio relies on historical data which means it does not account for all factors that will impact an investment’s return in the future. It doesn’t predict the future but it can determine past trends that may influence future events.
2. The Sortino ratio does not shed any light on upside volatility. Investors should use the Sortino ratio in conjunction with the Sharpe ratio and other metrics when assessing an investment to get a full picture.
3. If there is not enough negative volatility in the dataset, the Sortino ratio becomes irrelevant.
4. It can be difficult to compare similar investments if different benchmarks are used to calculate the Sortino ratio.

## Wrapping Up: There’s No Reason Not to Use the Sortino Ratio & Other Tools

When you’re running a business, you can’t afford to lose money in ill-considered investments.

No investment is free of risk but the Sortino ratio, in conjunction with other tools, can help you make informed decisions that you can justify to your colleagues and other stakeholders.

With a bit of luck, it may even help you generate more income from the money you invest.