CandleFocus

Sortino Ratio

Candlefocus Editor
The traditional definition of risk is the variability of returns. This traditional concept of risk is too broad — one of the problems with it is that it has a positive bias towards risk. It gives a weight to positive returns equal to that of negative returns; however, investors do not benefit twice from a single good outcome.

The Sortino Ratio offers a different view of risk. It was developed to narrow down the definition of risk, by only considering the downside risk. Downside risk is defined as the deviation from the mean that results in a negative return.

To calculate the Sortino Ratio, the downside volatility is first computed. This measure of risk is then divided by the excess return of a portfolio, which is its return minus its risk-free rate. The result is a risk-adjusted performance metric that provides insight into how much risk a portfolio is taking on, in order to generate a certain level of return.

The Sortino Ratio is a better way of measuring risk than the traditional definition because it excludes the upside volatility that can be beneficial to investors. The Sortino Ratio essentially evaluates whether an investor is taking on too much downside risk with a portfolio, in order to achieve an average return.

The Sortino Ratio is a valuable tool for investors, analysts and portfolio managers to measure risk-adjusted performance. It helps to identify when a portfolio’s downside risk is higher than its return potential is worth. In comparison with the traditional definition of risk, the Sortino Ratio provides a better assessment of risk and is a better measure of a portfolio's performance.

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