The Sortino ratio refines the well-known Sharpe ratio by focusing solely on downside volatility. Traditional standard deviation treats positive and negative swings equally. But investors usually welcome upside volatility while fearing losses. The Sortino ratio divides excess return by downside deviation, penalizing only the periods when the portfolio falls below a target or risk-free rate. This makes it useful for comparing strategies that aim for consistent returns with limited drawdowns.
The mathematical expression is:
where is the average portfolio return, is the risk-free rate, and the denominator is the square root of the average squared shortfall when returns dip below . By ignoring upside deviation, the ratio shows how effectively a strategy delivers excess returns relative to harmful volatility.
Higher Sortino values indicate better risk-adjusted performance. A ratio above 2 is considered excellent in many contexts, while a negative ratio signals that the portfolio fails to beat the risk-free rate on average. The metric is especially helpful for strategies with asymmetric returns, such as options or hedge funds, where traditional volatility measures can be misleading.
Enter a comma-separated list of percentage returns. These could represent daily, weekly, or monthly performance. Provide the risk-free rate in the same interval, such as monthly T-bill yield if you’re analyzing monthly returns. The script converts percentages to decimals, computes the arithmetic mean, and isolates downside deviations. The final output shows the Sortino ratio rounded to two decimals.
Suppose a portfolio produced monthly returns of 2%, -1%, 3%, and -0.5% over four months. If the risk-free rate is 0.2% per month, we calculate the negative deviations relative to that hurdle: -1.2% and -0.7%. Squaring, averaging, and taking the square root yields the downside deviation. Subtracting the risk-free rate from the average return gives excess return. Dividing these values produces the Sortino ratio, allowing you to judge whether the returns sufficiently compensate for downside risk.
While the Sortino ratio improves upon standard volatility measures, it still relies on past returns and assumes a consistent distribution over time. Extreme outliers or non-normal distributions can distort results. Use it alongside other metrics like drawdown, Sharpe ratio, and value at risk for a more complete picture.
By highlighting downside risk, the Sortino ratio helps investors select strategies that minimize painful losses. Conservative portfolios might strive for a higher Sortino ratio even if total returns are modest. Aggressive traders, meanwhile, might accept a lower ratio in pursuit of bigger gains. Understanding this balance lets you design an investment plan that fits your personal tolerance for risk.
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