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Sortino Ratio

Definition

The Sortino Ratio is a statistical tool used to measure the risk-adjusted return of an investment or portfolio. It differs from the Sharpe Ratio by taking into account the downside volatility (negative price fluctuations) rather than total volatility. The higher the Sortino Ratio, the better the investment or portfolio’s performance relative to its downside risk.

Phonetic

The phonetics of “Sortino Ratio” is: sɔrˈtiːnoʊ ˈreɪʃioʊ

Key Takeaways

<ol><li>Sortino Ratio is a statistical tool used to measure the performance of an investment, taking into account the downward risk. It is similar to the Sharpe Ratio, but it focuses only on the negative deviation of a portfolio’s returns rather than the overall volatility.</li><li>A higher Sortino Ratio indicates a lower probability of a large drop in the investment’s value. Therefore, it’s used by investors to identify investments or portfolios that have high returns with less risk of big losses. It is particularly useful for portfolios holding aggressive, risky assets with potentially high levels of negative volatility.</li><li>Though useful, the Sortino Ratio also has limitations. Specifically, it assumes that the distribution of investment returns is normal, which is often not the case in financial markets. It also may overestimate the return obtained from the investment by only measuring negative volatility. Therefore, it should not be the sole measure used in decision-making, but rather used in combination with other investment analysis tools.</li></ol>

Importance

The Sortino Ratio is a significant term in business/finance as it provides a more detailed evaluation of an investment’s performance compared to the standard Sharpe Ratio. This ratio focuses specifically on harmful volatility, instead of overall volatility, by only considering the downside, or negative volatility, for a particular investment. It measures the risk-adjusted return of an investment and helps investors to understand the return of an investment compared to the risk of negative returns. This makes the Sortino Ratio a powerful tool for investors when looking for investments with the highest return on the lowest downside risk, aiding them in making better, informed investment decisions.

Explanation

The primary purpose of the Sortino Ratio, a statistical tool used in finance, is to measure the risk-adjusted return of an investment, portfolio, or trading strategy. Named after Frank A. Sortino, it provides a more refined view of risk compared to other traditional risk measurement methods. What sets the Sortino Ratio apart from other performance measurement metrics is that it only takes into account the downward volatility or the negative deviation, ignoring the upward volatility or positive deviation. This particular focus makes it a valuable tool for investors who are risk-averse and want to account only for the negative risks associated with their investments.Most notably, the Sortino Ratio accounts for the fact that all volatility is not bad for investors. After all, volatility that represents returns exceeding the expected or average return is beneficial, something that many investors desire. The risk we should be concerned about is the risk of negative returns, or in other words, losing money. This is what the Sortino Ratio captures. By doing so, it allows investors or fund managers to compare the risk-adjusted performance of different portfolios or strategies, thereby aiding in decision-making where the aim is to maximize returns for a given level of risk.

Examples

1. Investment Portfolio Evaluation: Consider an investor who manages two investment portfolios, Portfolio A and Portfolio B. If Portfolio A has a Sortino Ratio of 2.5, and Portfolio B has a Sortino Ratio of 1.8, the investor can deduce that Portfolio A is the better investment because it has a higher risk-adjusted return than Portfolio B. 2. Mutual Fund Comparison: An individual wants to invest in one of two mutual funds. Mutual Fund X has a Sortino Ratio of 1.5 and Mutual Fund Y has a Sortino Ratio of 1.2. Even though both funds have similar returns, Fund X would be a better choice because it has a higher Sortino Ratio, indicating a lower risk of negative returns.3. Hedge Fund Performance Analysis: Hedge fund managers regularly use the Sortino ratio to analyze their performance. Suppose a hedge fund has a Sortino Ratio of 3.0 in the first year. If in the second year, the ratio drops to 1.8, it could indicate that either the fund’s returns have decreased or its downside risk has increased. This change would prompt the fund manager to reevaluate the strategies employed, make necessary alterations, or can serve as a signal to the investors about the heightened risk.

Frequently Asked Questions(FAQ)

What is Sortino Ratio?

The Sortino Ratio is a statistical risk-adjusted measure of a fund or investment’s performance. It differentiates harmful volatility from volatility in general by only taking into account the frequency and severity of negative returns.

How is the Sortino Ratio calculated?

The Sortino Ratio is calculated by subtracting the risk-free rate of return from the portfolio’s rate of return, and then dividing by the downside deviation.

What purpose does the Sortino Ratio serve?

The Sortino Ratio is used by investors to assess risk-adjusted return on an investment or portfolio. It helps them understand how much return they are getting in relation to the level of bad risk they are taking on.

How does the Sortino Ratio differ from the Sharpe Ratio?

Both are measures of risk-adjusted returns. However, while the Sharpe Ratio considers total volatility including both the upward and downward, the Sortino Ratio only focuses on the harmful volatility (downside deviation), hence it provides a more accurate measure of risk.

What does a high Sortino Ratio mean?

A high Sortino Ratio indicates a low probability of a substantial loss because it shows that the investment or portfolio has a superior risk-adjusted return relative to its peers.

Is it better to have a higher or lower Sortino Ratio?

Generally, a higher Sortino Ratio is viewed as better because it indicates that the investment is scoring high returns without taking excessive risk for those returns.

Can the Sortino Ratio be used for all types of investments?

Yes, it can be applied to any type of investment for which there is a historical record of returns and an understanding of the risk-free rate of return.

What would be considered a good Sortino Ratio?

This can depend greatly upon the specific investment scenario. However, in general terms, a Sortino Ratio above 1.0 is considered good, over 2.0 is very good, and over 3.0 is excellent.

Related Finance Terms

  • Downside Risk: A measure of an investment’s potential to lose value due to market or industry-related downturns.
  • Target Return: The level of return an investor expects to achieve from an investment.
  • Standard Deviation: A statistical measure that reflects the degree of price volatility or market risk associated with an asset or portfolio.
  • Risk-Adjusted Return: An investment’s profits or losses in relation to the amount of risk it carries.
  • Portfolio Management: The process of strategically selecting and managing different investment products and asset classes to achieve a desired balance of risk and return.

Sources for More Information

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