What is Sortino ratio?

The Sortino ratio is a score that compares how much an investment returned with how much it fell along the way. It belongs to the same family as the Sharpe ratio, created by William F. Sharpe, which divides return by volatility. Volatility measures how widely returns swing around their average in either direction. The Sortino ratio makes one change: it ignores the upward swings and counts only the bad ones. These are the periods when returns came in below a chosen target, often zero or the risk-free rate (the return on very safe short-term government debt). A higher number means more return was earned for each unit of downside.

Say a portfolio returns +20%, +15%, −10% and +11% over four hypothetical years, and the target is 0%. The average return is (20 + 15 − 10 + 11) ÷ 4 = 9%. To find the downside deviation, each year's shortfall below the target is squared, and years above the target count as zero: 0, 0, 100 and 0. The average of those is 100 ÷ 4 = 25, and its square root is 5%. The Sortino ratio is then (9% − 0%) ÷ 5% = 1.8. Using a risk-free rate of, say, 3% as the target would change both the top and the bottom of the calculation and give a lower figure.

Because it looks only at below-target periods, a short history with few losses can produce a large and flattering ratio, and four years, as in the example, is far too short to draw conclusions from. The result also depends on the target chosen and on whether daily, monthly or annual returns are used, so ratios are only comparable when calculated the same way. It says little about how losses cluster. Several small losing months in a row can add up to a deep drawdown, the fall from a previous peak, which maximum drawdown captures more directly. Like every ratio built on past returns, it describes history, not the future.

Most investors do not mind returns that surprise on the upside. Losing money is what tests their patience. The Sortino ratio matches that experience, which makes it useful for comparing assets or portfolios with lopsided swings, such as one that rises steadily but occasionally falls hard. For a private investor building a long-term portfolio, reading it alongside the Sharpe ratio and maximum drawdown gives a fuller picture of whether a return came with a level of risk that could be lived with through a bad stretch.

By Dr. Harry Hamann

What is the difference between the Sortino ratio and the Sharpe ratio?
Both divide return by a measure of risk. The Sharpe ratio uses volatility, which counts upward and downward swings alike. The Sortino ratio uses downside deviation, which counts only returns below a target. For an investment with lopsided returns, the two can rank it quite differently.

What is a good Sortino ratio?
There is no universal threshold. Higher means more return per unit of downside, but the figure depends on the period, the return frequency and the target used. It is most meaningful when comparing investments measured over the same period with the same method.

How is downside deviation calculated?
Each period's shortfall below the target is squared. Periods at or above the target count as zero. These values are averaged over all periods, and the square root of that average is the downside deviation.

Can the Sortino ratio be negative?
Yes. If the average return is below the target, the top of the calculation is negative, so the ratio is negative. This shows the investment did not even reach the chosen target over the period measured.