It is important to weigh both, the risks as well as the rewards when investing in any particular investment scheme. The risks of an investment scheme can be broadly grouped as upside risks and downside risks. An upside risk is a potential financial gain, whereas a downside risk is a potential financial loss. There are various financial ratios that help investors measure the risks associated with an investment scheme.
For example, Sharpe Ratio is a very popular financial tool that helps assess risk. This ratio indicates the amount of extra return you get for the extra risk you take by holding a more volatile asset.
Thus, while the Sharpe ratio is a measure of risk-adjusted performance, the Sortino ratio is a similar measurement, but it takes into account the downside risk of the investment.
What is Sortino Ratio?
Sortino Ratio is a statistical tool that focuses only on the negative deviation of a portfolio’s returns from the mean. It takes into account the historical asset returns, the risk-free rate, and the negative asset volatility to determine how much profit you can earn in exchange for the risk you take. It is thus, thought to represent a better view of a portfolio’s risk-adjusted performance.
A higher Sortino Ratio means a lesser probability of downside deviation in the investment scheme.
You can use the Sortino Ratio to assess an investment scheme’s ideal holding period or investment horizon and risk tolerance level.
The Sortino Ratio is a comparative tool and thus is not meaningful when viewed in isolation.
A rational investor would prefer an investment with a higher Sortino ratio over one with a lower ratio because it implies that the investment earns a higher return per unit of bad risk.
Formula and Calculation of Sortino Ratio
The Sortino ratio is calculated by dividing the difference between the return and risk-free return rates by the standard deviation of the negative returns.
The formula used to calculate the Sortino ratio is-
Sortino Ratio = (Average Asset Return – Risk Free Rate) / Standard Deviation of Downside Risk
- Average Asset Return: Average of the asset’s past returns.
- Risk Free Rate: The profit you can make with literally no risk of losing money.
- Standard Deviation of Downside Risk: This only considers the negative returns, replacing the positive values in the historical returns by 0.
For example, there are two portfolios X and Y with an annualized return of 10 % and 15 respectively. The downward deviation is 12% and 4% respectively. Assume that risk free rate is 6%.
Sortino Ratio for both will be calculated as:
Sortino Ratio of X= (10-6)/12= 0.3333
Sortino Ratio of Y= (15-6)/4= 2.25
|Expected returns||Risk free rate||Standard deviation||Sortino Ratio|
Here, portfolio Y is having higher ratio compared to portfolio X. Portfolio Y indicates more it is generating more returns by taking risks. Portfolio X is at more risk of loss compared to portfolio Y.
How can you use the Sortino Ratio?
The Sortino ratio can help you to choose the right investment scheme to invest in by calculating the returns considering the downside risks.
The Sortino ratio is a great risk measure that can provide a more accurate interpretation of risk. It is particularly useful for investors who are seeking to minimize risk.
What is a good Sortino ratio?
Remember, when comparing investment schemes, the one with a larger Sortino ratio is better.
- Sortino ratio > 1: a good risk/return profile.
- Sortino ratio > 2: a great profile.
- Sortino ratio > 3: an excellent profile.
A negative Sortino ratio, indicates that the investor could have achieved a better return with lower risks. Simply put, it means the investor took more risks and still got poorer results.
Things to remember
Consider these points when using the Sortino ratio, which measures the returns of a scheme in light of its downside risks.
- The time frame of your investment: If you select a scheme based on the Sortino ratio, you should examine its past performance over the past few years. You will then have a good idea of its performance through both positive and negative moves.
- The liquidity of the scheme: Using the Sortino ratio of an illiquid scheme might make the risk-free return seem favourable, but it’s only because of the instrument’s illiquidity.
In conclusion, the higher the Sortino ratio the better. So, an investment scheme with a higher Sortino ratio is the one you should choose but make sure you also take into effect other factors like the past performance, expertise of the fund manager, your risk profile, investment horizon, etc.