Volatility is commonly where profits lie in day trading. But sometimes volatility is dangerous. A variation of the Sharpe ratio, called the Sortino ratio, will help you recognize when volatility is harmful as opposed to the volatility that always shapes the markets. It evaluates downside deviation rather than the total standard deviation of all portfolio returns. Thus, it uses the standard deviation of negative portfolio returns of an asset. The Sortino ratio takes the risk-free rate from an asset’s return and divides by its deviation to the downside. The indicator is named for its inventor, Frank A. Sortino.

Sortino Ratio vs Sharpe Ratio

The Sortino Ratio is like the Sharpe ratio. However, Frank Sortino set up his ratio to assess only downside volatility. The Sharpe ratio looks at volatility to the upside as well as the downside. Otherwise, the calculations are the pretty much the same. They both look at deviation of portfolio returns, apply the standard deviation of returns to any given asset and take the risk-free rate from the return of an asset as divide it by its standard deviation. The Sharpe ratio provides insight in both up and down directions while the Sortino ratio is limited to the downside.

What Is a Good Sortino Ratio?

A negative Sortino Ratio tells you that your investment is losing money. The point of investing is to put money aside and then let it grow. Investors need to consider risks as well as return when investing and the Sortino Ratio helps with that. As a rule, a Sortino ratio of 0 to 1 is poor and a Sortino Ratio of 1 to 2 is acceptable. What you want to see are Sortino ratios of 2 to 3 which is very good or 3 to 4 which is excellent. Where you should apply the Sortino ratio is when looking at returns on your own portfolio or on any fund in which you are investing your money.

Sortino Ratio Definition

The Sortino Ratio measures risk-adjusted performance. Unlike the Sharpe ratio it only looks at downside risk. Think of the Sortino Ratio as a measure of portfolio or fund quality based on its return excess to risk. While the Sharpe ratio looks at upside movement as well many investors consider that superfluous because everyone is happy with a successful portfolio. The reason to use the Sortino Ratio is to sort out how downside risk and volatility are erasing your gains in an otherwise strong set of investments. One bad apple in the barrel can erase your gains in everything else. The Sortino Ratio helps you avoid that.

Sortino Ratio Calculation

The point of doing a Sortino Ratio calculation on your own portfolio or on a fund in which you invest your money is to sort out the forest from the trees. Are you getting a good rate of return of are you being undercut by risky investments? The calculation goes day by day looking at performance and compares the results to a minimal acceptable return that you determine beforehand. You can use the interest rate of a AAA bond, an inflation-adjusted US Treasury, or the S&P 500 as a comparison. The end result will be a clearer picture of your investment risks and overall return.

Sortino Ratio Formula

This is the formula for calculating the Sortino Ratio.

Sortino Ratio = (Rp – MAR)/DDmar

Rp is your portfolio return
MAR is your minimal acceptable return
DDmar is the downside deviation

This the DDmar calculation.

DDmar = Square root of (1/n times the sum from t=1 to n of min (Rt-MAR),9) squared

Rt is the return for day t
n is the period considered
MAR is the minimal acceptable return

The good part of this is that there are programs the will do this tedious set of calculations for you!

High Sortino Ratio

The obvious goal in all of this is to have a high Sortino Ratio. However, events that one cannot control like global pandemics and autocratic regimes threatening the peace of Europe and world tend to intervene. At such times you may find that your Sortino Ratio suffers. It is at those time that you need to look through your portfolio to see where the downward volatility lies. You will need to make decisions about which assets are likely to recover and which will suffer long term damage. In the end, you will aspire to a Sortino Ratio above 3 but you should be happy with a 2 to 3 ratio until events beyond your control work towards solutions.

Adjusted Sortino Ratio

Many portfolio and fund managers use either the Sharpe Ratio or the Sortino Ratio or both in analyzing returns. A major advantage of using indicators that measure day by day performance is that you will see when a stock falls by 10% and then recovers by 10.5% within a month. Rather than seeing a moderate 0.5% gain in a month you see a lot of volatility. Because the Sortino Ratio only looks at downside risk it gives skewed results when compared to the Sharpe Ratio. Thus, a square root is introduced into the calculation to even this out.