Retail investors often struggle to select the ‘right’ investment scheme that matches their financial requirement and investing capability. However, with the help of financial ratios like the Sortino ratio, they can evaluate a scheme’s performance in a much better manner.
What is the Sortino Ratio?
Fundamentally, the Sortino ratio is a statistical tool that proves useful in measuring the performance of an investment with respect to downward deviation. This ratio does not account for the volatility in investment.
It helps to represent a realistic idea about the downside risks that accompany a stock or a fund. In other words, this ratio helps to measure risk-adjusted returns of a particular investment scheme.
Sortino ratio is a suitable statistical tool for retail investors as they are more concerned about downside risks that accompany investments. It focuses on the negative deviation of an investment portfolio and its returns and thus offers a better idea about such a portfolio’s performance after potential risks have been adjusted.
How is the Sortino Ratio Calculated?
The Sortino ratio is computed by dividing the difference between the aggregated earnings of an investment portfolio and the risk-free rate of return with the standard deviation of negative earnings.
Sortino ratio formula is given by –
Sortino ratio = R – Rf /SD
R equals the expected returns
Rf refers to the risk-free return rate
SD equals the negative asset return’s standard deviation
It must be noted that though the computation is quite similar to that of the Sharpe ratio (a standard measurement tool of risk-return trade-offs), there is one significant difference between them.
To elaborate, the Sortino ratio uses only the downside volatility to evaluate a portfolio’s performance. On the other hand, the Sharpe ratio uses both the upside and downside volatility.
Example of Sortino Ratio Calculation
Let’s take a look at this Sortino ratio example to understand how it is computed –
Suppose, there are two investment portfolio schemes, namely – Scheme T and Scheme F with annualised returns.
|Particulars||Scheme T||Scheme F|
|Rate of fixed deposit risk-free||6%||6%|
From the above information,
Scheme T’s Sortino ratio =
(R) – Rf /SD
Scheme F’s Sortino ratio =
(R) – Rf /SD
Typically, a higher Sortino ratio in mutual funds is considered to be better. So from the given outcome, Scheme T’s Sortino ratio indicates that it is generating more return per unit of the given risk and in turn has a greater chance of avoiding large losses.
Significance of Sortino Ratio
This ratio tends to address the shortcomings of standard deviation as a measure of potential risks in a return and risk trade-off ratio.
It is essential to acknowledge the specific asset class of investment schemes, to evaluate an investment portfolio’s performance more accurately. Also, there are certain limitations of the Sortino ratio that investors and financial analysts must be aware of beforehand.
Limitations of Sortino Ratio
The fact that since this ratio uses the downside deviation method to measure risk aspect, the shortcomings of the same influence it significantly. For instance, with downside deviation, there has to be enough ‘bad’ risks or observations to begin with for the resulting outcomes to be statistically noteworthy.
Difference between Sortino Ratio and Sharpe Ratio
Notably, both ratios are a risk-adjusted measure of returns on investment. Regardless, there are a few essential points of differences that set them apart.
The table below focuses on the fundamental differences between the Sortino ratio and Sharpe ratio –
|Parameters||Sortino ratio||Sharpe ratio|
|Definition||It is an improved variation of Sharpe ratio. It only accounts for the downside risks that accompany an investment portfolio.||It indicates how efficiently equity is performing when compared to a risk-free investment scheme.|
|Usage||Sortino ratio is used to evaluate investment portfolios with high volatility.||Sharpe ratio is used to evaluate investment portfolios that are low on volatility.|
|Calculation||Sortino ratio calculation is done by subtracting the investment portfolio’s total earnings from the risk-free rate of return and is then divided by the standard deviation of negative earnings.||It is computed by deducting the rate of earnings of a risk-free investment from the anticipated return on an individual stock (or equity portfolio) and is then divided by the standard deviation of the investment portfolio.|
|Formula||Sortino ratio = (R) – Rf /SD||Sharpe Ratio = (Rx – Rf) / Std Dev Rx|
|Significance of outcome||A ratio that is either one or higher is considered to be risk-adjusted return of earnings.||A negative ratio suggests that an investor will secure a better risk-adjusted rate of earnings with the help of a risk-free investment option.|
Investors and financial analysts should make sure that the ratio they plan on using is competent enough to offer them accurate results. On that note, individuals must understand the shortcomings of the Sortino ratio and find a way to work around it to gauge the proficiency of an investment scheme successfully.