The Sortino ratio is a powerful risk metric that addresses a key flaw in the Sharpe ratio. Developed by Frank Sortino, this ratio focuses specifically on harmful volatility, recognizing that investors are not worried about upside surprises. This guide explains how the Sortino ratio works and why it may be a better measure for your portfolio.
What is the Sortino Ratio?
The Sortino ratio measures risk-adjusted return using only downside deviation instead of total standard deviation. It penalizes only negative volatility, the kind investors actually want to avoid.
The Sortino Ratio Formula:
Sortino Ratio = (Portfolio Return - Target Return) / Downside Deviation
Unlike the Sharpe ratio, upside volatility does not reduce your Sortino ratio.
The Problem with the Sharpe Ratio
The Sharpe ratio treats all volatility as bad. But think about it: if your portfolio jumps 20% in a month, that creates high volatility, yet you are happy about it. The Sharpe ratio penalizes this positive surprise the same as a 20% drop.
Example: Why Sharpe Can Be Misleading
Two portfolios with the same 15% average return:
- Portfolio A: Steady returns, occasional big gains
- Portfolio B: Steady returns, occasional big losses
If both have the same standard deviation, they have the same Sharpe ratio. But clearly Portfolio A is better. The Sortino ratio would correctly show Portfolio A as superior.
Understanding Downside Deviation
Downside deviation only counts returns that fall below a target or threshold. There are two common approaches:
- Target return of zero: Measures volatility of all negative returns
- Target return = risk-free rate: Measures volatility of returns below T-bills
- Custom target: Measures volatility below your required return
Example: Calculating Downside Deviation
Monthly returns: +5%, -3%, +2%, -4%, +8%, -1%
Target return: 0%
Returns below target: -3%, -4%, -1%
Downside deviation = Square root of average squared negative returns
= Square root of [(9 + 16 + 1) / 6] = Square root of 4.33 = 2.08%
Calculating the Sortino Ratio Step by Step
Here is how to calculate the Sortino ratio:
- Gather your periodic returns (monthly, quarterly, etc.)
- Choose a target or minimum acceptable return
- Calculate downside deviation (only returns below target)
- Compute average return minus target return
- Divide excess return by downside deviation
Example: Full Sortino Ratio Calculation
Annual data:
- Portfolio return: 12%
- Target return (risk-free rate): 2%
- Downside deviation: 8%
Sortino Ratio = (12% - 2%) / 8% = 10% / 8% = 1.25
This means you earn 1.25% of excess return for each 1% of downside risk.
Interpreting Sortino Ratio Values
Guidelines for evaluating Sortino ratios:
- Below 0: Returns below target with downside volatility (poor)
- 0 to 1: Modest risk-adjusted returns
- 1 to 2: Good risk-adjusted returns
- Above 2: Excellent downside risk management
Important note: Sortino ratios are typically higher than Sharpe ratios for the same portfolio because they only count downside volatility. Do not compare a Sortino ratio to a Sharpe ratio directly.
Sortino vs Sharpe: When to Use Each
Use Sortino Ratio When:
- You care primarily about avoiding losses
- The investment has asymmetric returns (options strategies, trend following)
- You want to compare strategies with different volatility profiles
- The investment might have large positive outliers
Use Sharpe Ratio When:
- Returns are approximately normally distributed
- You want a simpler, more widely understood metric
- Comparing with industry benchmarks that use Sharpe
- Analyzing investments where upside and downside volatility are similar
Practical Applications
1. Evaluating Option Strategies
Selling options creates asymmetric returns: many small gains and occasional large losses. The Sortino ratio better captures this risk profile than the Sharpe ratio.
2. Trend-Following Systems
Momentum strategies often have many small losses and occasional large gains. Sortino ratio will not penalize the large gains, giving a fairer risk assessment.
3. Comparing Fund Managers
Two managers with equal Sharpe ratios may have very different Sortino ratios if one experiences more downside volatility.
Example: Real Comparison
Two managers with identical Sharpe ratios of 0.8:
- Manager A: Sortino ratio 1.8 (upside volatility dominant)
- Manager B: Sortino ratio 0.9 (balanced volatility)
Manager A delivers better downside protection despite similar overall risk-adjusted returns.
Limitations of the Sortino Ratio
The Sortino ratio is not perfect:
- Target sensitivity: Results change based on chosen target return
- Sample size issues: Need enough data to calculate downside deviation accurately
- Less familiar: Not as widely used or understood as Sharpe ratio
- Does not capture tail risk: Extreme events may not be fully reflected
- Historical data: Past downside deviation may not predict future
Tips for Using the Sortino Ratio
- Be consistent with target return: Use the same target when comparing investments
- Use sufficient data: Monthly returns for at least 3 years is recommended
- Combine with other metrics: Use alongside Sharpe ratio and maximum drawdown
- Verify unusually high values: Extremely high Sortino ratios warrant investigation
- Consider the investment type: Sortino is especially valuable for asymmetric strategies
Calculate Your Portfolio's Sortino Ratio
Pro Trader Dashboard calculates your Sortino ratio automatically, giving you a clearer picture of your downside risk management and true risk-adjusted performance.
Summary
The Sortino ratio provides a more nuanced view of risk-adjusted returns by focusing only on downside volatility. For many investors, this is a more relevant measure of risk than the Sharpe ratio. By using both metrics together, you can better understand whether your portfolio is truly well-managed or simply benefiting from positive volatility that masks underlying downside risk.
Continue learning about risk metrics with our guides on maximum drawdown and the Sharpe ratio.