The Sortino ratio is a variant of the Sharpe ratio that uses the asset’s standard deviation of negative portfolio returns, or downside deviation, rather than the total standard deviation of portfolio returns to distinguish between detrimental volatility and overall volatility. The Sortino ratio divides the amount left over after deducting the risk-free rate from the return on an asset or portfolio by the asset’s downside deviation.
In contrast to the Sharpe ratio, the Sortino ratio only takes into account the standard deviation of the downside risk, not the total (upside Plus downside) risk.
The Sortino ratio is said to provide a better picture of a portfolio’s risk-adjusted performance since it only considers the negative deviation of a portfolio’s returns from the mean as positive volatility represents a gain.
Investors, analysts, and portfolio managers can assess an investment’s return for a specific degree of bad risk by using the Sortino ratio.
A higher result for the Sortino ratio is preferable, just like the Sharpe ratio. A reasonable investor would choose the investment with the higher Sortino ratio when comparing two similar investments since it indicates that the investment is earning more return per unit of the negative risk that it assumes.
By dividing excess return by the downside deviation rather than the overall standard deviation of a portfolio or asset, the Sortino ratio outperforms the Sharpe ratio by separating downside or negative volatility from total volatility.
Investors receive positive returns because the Sharpe ratio penalizes investments for taking on good risk. The investor’s preference for focusing on total, standard, or merely downside deviation will choose which ratio to utilize.
