• Economics , Finance ,
• 02 Jul

The Sortino Ratio is a risk vs return metric. This is named after Frank A. Sortino. A higher Sortino Ratio equates to less risk while a smaller one means more risk. It attempts a similar goal as the Sharpe ratio but only looks at the downside risk.

The idea is that investors should only concern themselves with the negative volatility.  This was something that Sortino was widely known for. A criticism of the Sharpe ratio is the way it treats positive volatility. You’d think that a performance metric would promote positive volatility yet the Sharpe ratio does the opposite. In this way, the Sortino ratio removes this positive swing out of the equation. Let’s take a look at the math.

Sortino Ratio

where

Portfolio Return

Risk-Free Rate

Standard deviation of the downside

Portfolio Return

This is the return that the portfolio provides and is a weighted sum of all the pieces that make up the portfolio returns for a period. We go more in depth in our article about Portfolio Return.

Risk-Free Rate

This is the return that you can expect with a risk-less investment. We use the U.S. Treasury Bills or “T-Bill’s interest rate is “. To get this number, we suggest that you go straight to the source. Treasury.gov has yield curve rates. Typically we use 10-year, but other sources state the 3 month T-bill being acceptable. Some argue that a 10-year or 30-year bond cannot adjust to inflation the way a 3 month can. It really depends on the time horizon in question. If you include this in your assumptions and explain why, it helps support your results.

Standard deviation of the downside

This is the part where we isolate the downside. This is done by taking the standard deviation of only the negative returns. Before calculating the standard deviation, you’ll need to take out all of the positive returns .