Every investor wants to earn more money from their portfolio, but putting money into stocks and even funds can be risky. The Sortino ratio indicates how much risk an investor is taking on with their positions.
It has a similar function to the more popular Sharpe ratio, but it is more focused on downside risk, also referred to as downside deviation. Frank Sortino, director of the Pension Research Institute in Menlo Park, California, developed the ratio in the early 1980s.
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A higher Sortino ratio is better for a portfolio. A higher ratio is a sign that the portfolio is achieving good returns relative to the risk that it is incurring. For instance, a bond investor may be happy with a 5% annualized return because these assets involve taking less risk to produce lower returns than, say, a growth stock.
However, a stock investor picking growth-oriented assets won’t be as happy with a 5% return. Even though the growth investor and the bond investor achieve the same return in this scenario, the bond investor will have the better Sortino ratio. Growth investors should aim for a return higher than 5%, given the additional risks they are taking.
Here’s what you need to know about the Sortino ratio and how investors use it to make decisions:
— How to calculate the Sortino ratio.
— Sortino ratio example.
— Advantages of the Sortino ratio.
— Disadvantages of the Sortino ratio.
— Sortino ratio vs. Sharpe ratio.
How to Calculate the Sortino Ratio
The Sortino ratio uses three inputs for its formula. The numerator is the difference between a portfolio’s return and the risk-free rate of return. You can use a portfolio’s actual or expected return. Investors can use U.S. Treasury bill rates as the risk-free rate of return. The denominator is the standard deviation of a portfolio’s downside volatility.
Here’s the formula for the Sortino ratio:
(portfolio return – risk-free rate) / standard deviation of downside volatility
Sortino Ratio Example
The following examples of applications of the Sortino ratio formula demonstrate how calculating risk-adjusted returns can benefit investors. The first example is a bond portfolio that has achieved a 5% return over the past year. The second example is a growth portfolio that has also generated a 5% return over the past year.
These calculations will assume a risk-free rate of return of 3%. The less risky bond portfolio will have a 7% downside deviation, while the riskier growth portfolio will have a 20% downside deviation.
Bond portfolio Sortino ratio = (5% – 3%) / 7% = 0.29
Growth portfolio Sortino ratio = (5% – 3%) / 20% = 0.10
The bond portfolio has higher risk-adjusted returns than the underperforming growth portfolio. However, some growth portfolios outperform the market and end up with much higher Sortino ratios. This formula will make the same assumptions, but the growth portfolio will have a 25% return.
Updated growth portfolio Sortino ratio = (25% – 3%) / 20% = 1.1
Bond portfolios often have a low Sortino ratio because these assets are inherently less risky than stocks. When growth stocks perform well, these portfolios can end up with a higher Sortino ratio, which can indicate a solid portfolio in terms of risk versus reward.
[READ: 8 Key Investment Ratios for Stock Picking.]
Advantages of the Sortino Ratio
The Sortino ratio uses the standard deviation of downside volatility as its denominator, while the arguably simpler and more popular Sharpe ratio considers both the standard deviations of upside and downside volatility.
Preferred by Some Experts
Robert Johnson, professor of finance in the Heider College of Business at Creighton University, explains why the focus on downside volatility risk makes the Sortino ratio a better choice for investors: “The Sortino ratio implies that upside volatility is good and that only downside volatility should be considered in calculating the risk measure. This makes intuitive sense. Who says, ‘This asset is too risky for me; its price is rising too fast?'”
Johnson adds, “Upside volatility is a positive, and downside volatility is a negative, so in the true risk sense, downside volatility is the only volatility that most investors consider.”
Can Help Minimize Investment Losses
The Sortino ratio can also help investors make more informed decisions when buying funds. The ratio can give you an idea of what type of loss can happen if the stock market endures a correction.
In other words, knowing this information in advance can help risk-averse investors minimize their downside, says Bryan Cannon, a certified financial planner, CEO and chief portfolio strategist of Cannon Advisors. “The Sortino ratio helps investors gauge how well an investment or portfolio performs during unfavorable market conditions.”
Indicates Consistent Long-Term Returns
Furthermore, funds with higher Sortino ratios over extended periods of time tend to generate more consistent returns. While past results are not a guarantee of future success, a fund with gradual growth may look more appealing than a fund with sharp and sudden drops.
Disadvantages of the Sortino Ratio
Every financial metric has strengths and weaknesses. It’s important for investors to know the potential risks of relying on one measurement and use multiple data points before making decisions.
May Give a False Sense of Security in the Short Term
One of the weaknesses of the Sortino ratio also applies to the Sharpe ratio. The ratio is less valuable if you use a shorter time frame. A three-year Sortino ratio can present a false sense of security if the stock market has enjoyed a long bull run. A lengthier time frame, like a 10-year Sortino ratio, is more reliable because the stock market has likely endured an economic contraction during that time.
A lengthier time period will help, but the Sortino ratio is still a lagging indicator. A fund with a high Sortino ratio isn’t guaranteed to outperform the stock market in the future.
For example, the Ark Innovation ETF (ticker: ARKK) was a top fund from 2016 to 2021. ARKK had a high three-year Sortino ratio during those years. However, most of the fund’s stocks were in bubbles that burst in 2021. The ARKK fund is now down by more than 60% from its all-time high.
Doesn’t Account for Other Important Factors
Investors should review a fund’s positions and analyze the top stocks in conjunction with using the Sortino ratio. Looking at a fund’s managers, expense ratio and historical returns can also help with making a better decision.
It’s also important to consider the ratio’s assumptions on expected returns, the risk-free rate and the downside deviation. Different opinions on these numbers can lead to different Sortino ratios. Getting these numbers wrong can greatly exaggerate the risk or safety of a fund.
Does Not Address Potential Gains
While some investors want to prioritize downside risk and create plans around it, this ratio does not assess potential gains. A riskier portfolio will have more potential to outperform the market and reward investors. However, upside volatility is not a part of the equation and can make growth portfolios look less attractive.
Sortino Ratio vs. Sharpe Ratio
The Sortino and Sharpe ratios both measure risk-adjusted returns for funds and portfolios. These funds have the same numerators, but the Sharpe ratio also includes upside volatility in its denominator, as follows:
Sharpe ratio = (return – risk-free rate) / standard deviation
Cannon suggests determining if you are a growth-oriented investor or are more risk-averse before deciding which ratio to use. “Investors choose between them based on their emphasis on either overall or downside risk in their portfolio decision-making,” he says.
“The Sortino ratio focuses solely on downside volatility, providing a more targeted evaluation of an investment’s performance during unfavorable conditions,” Cannon explains. “The Sharpe ratio considers both upside and downside volatility in its calculation, offering a broader perspective on risk-adjusted returns.”
Because the Sortino ratio focuses only on the downside deviation and does not consider upside and downside as equally risky, as the Sharpe ratio does, some investors see it as a better gauge of risk-adjusted returns.
The Sortino ratio is especially suited to investors who are concerned with the risk-adjusted return of a volatile investment portfolio, or any investment if they have a low risk tolerance. The widely used Sharpe ratio is also useful in comparing a fund’s overall impact on a portfolio when risk is taken into consideration.
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What Is the Sortino Ratio? Formula and Example originally appeared on usnews.com
