What is the difference between the Sharpe Ratio and the Sortino Ratio

The Sharpe ratio is used more to evaluate low-volatility investment portfolios, and the Sortino variation is used more to evaluate high-volatility portfolios. Read the article to explore more.
Difference between the Sharpe Ratio and the Sortino Ratio
3 min
29 March 2024

If you are planning to invest in market-linked assets like stocks or mutual funds, it is not enough to simply compare the returns of different investments before making a choice. You need to also evaluate the risk-adjusted returns. Financial metrics like the Sharpe ratio and the Sortino ratio can help you with this.

In this article, we examine the meaning of these ratios and explore the Sortino ratio vs Sharpe ratio comparison.

What is the Sharpe ratio

The Sharpe ratio is a metric that evaluates the risk-adjusted returns of stocks and mutual fund schemes. Originally known as the reward-to-variability ratio, it was first developed by William F. Sharpe as a progression of his propositions about the Capital Asset Pricing Model (CAPM).

This ratio essentially tells you how much excess returns you earn from an asset for every unit of risk and volatility that you take on. It is particularly useful for evaluating highly volatile assets because it helps you see if the additional risk is set off by potentially higher risk-adjusted returns.

Sharpe ratio calculation

To calculate the Sharpe ratio, you need to compare the excess returns from an asset or portfolio with its standard deviation. The formula for this ratio is:

Sharpe ratio = (Rp — Rf) ÷ σp

Where:

Rp is the expected returns from the portfolio or fund

Rf is the risk-free rate

σp is the standard deviation of the portfolio or fund

What is the Sortino ratio

The Sortino ratio, like the Sharpe ratio, also helps you measure the risk-adjusted returns of a mutual fund, stock or portfolio. However, it only focuses on the downside risk or the standard deviation of the losses from a portfolio. In other words, it tells you the excess returns you can earn from a mutual fund or portfolio for every unit of downside risk you assume by investing in it.

The main difference between the Sortino ratio and the Sharpe ratio is the kind of volatility considered. While the Sharpe ratio assesses the risk-adjusted returns for the total volatility of an asset, the Sortino ratio tells you the excess returns you earn for the harmful volatility you endure.

This distinction is important because not all volatility is adverse. If the price of an asset or mutual fund moves in a favourable direction, it improves the risk-adjusted returns instead of eroding your gains.

Sortino ratio calculation

The formula to calculate the Sortino ratio is similar to the Sharpe ratio formula. The only difference between the Sortino ratio and the Sharpe ratio formulas is the type of standard deviation used. Check out the formula for the Sortino ratio.

Sortino ratio = (Rp — Rf) ÷ σp

Where:

Rp is the expected returns from the portfolio or fund

Rf is the risk-free rate

σp is the standard deviation of the negative or downside returns from the asset or portfolio

Sharpe ratio vs Sortino ratio: The key differences

Now that you have seen the fundamentals of the Sortino ratio vs Sharpe ratio comparison, let us examine these details further. The table below summarises the differences between the Sortino ratio and the Sharpe ratio.

Particulars

Sharpe ratio

Sortino ratio

What it measures

The excess returns received for the extra volatility in a riskier asset

The excess returns received for the extra negative volatility in an asset

The type of volatility considered

Considers the total volatility of an asset, thereby including both gains and losses

Considers only the downside volatility, thereby focusing specifically on losses or negative returns

Sensitivity

Reacts to both positive and negative changes in the price or asset value

Reacts only to negative changes in the asset value and ignores any positive performance

Use cases

Useful for general risk-adjusted performance assessment of investments

Useful for evaluating investments where protection against downside risk is a priority

 

How are the Sharpe ratio and the Sortino ratio used in investing

The Sharpe ratio and the Sortino ratio can be useful in different ways. Before you make a lump sum or SIP investment in a mutual fund or take a long position in any other asset, you can use the Sharpe ratio to evaluate the risk-adjusted performance of the asset. It also helps you compare mutual funds and optimise the risk-reward proposition in your existing portfolio.

The Sortino ratio is crucial for assessing the downside risk in any investment. It can also help you assess investment strategies and plays a pivotal role in performance benchmarking.

Conclusion

This sums up the Sortino ratio vs the Sharpe ratio comparison. The bottom line is that the Sharpe ratio and the Sortino ratio are both useful if you want to assess and compare mutual funds to make a smart investment decision. To choose from a variety of mutual funds in different categories with varying risk-adjusted returns, check out the 1,000+ mutual fund schemes on the Bajaj Finserv Platform.

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Frequently asked questions

What is a good Sortino ratio?

A Sortino ratio of 2 or higher is considered to be good for investors because it means that the mutual fund or portfolio generates enough excess returns to cover the downside risk at least twice over.

How is the Sortino ratio calculated?

To calculate the Sortino ratio, you need to divide the excess returns from a portfolio by its negative volatility. The difference between the portfolio’s expected returns and the risk-free rate represents the excess returns. Meanwhile, the standard deviation of an asset’s negative returns represents the negative volatility.

What is a good Sharpe ratio?

A higher Sharpe ratio is always better. As a rule of thumb, a Sharpe ratio between 1 and 2 may be quite good, while a ratio ranging from 2 to 3 may be very good. If the ratio exceeds 3, it is considered excellent.

What is the difference between the Sharpe ratio and the Sortino ratio?

The main difference between the Sortino ratio and the Sharpe ratio lies in the type of volatility or standard deviation considered. While the Sharpe ratio accounts for all kinds of volatility (i.e. the standard deviation of the portfolio’s overall returns), the Sortino ratio only focuses on negative volatility (i.e. the standard deviation of the portfolio’s negative returns or losses).

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