The Sortino ratio, an adaptation of the Sharpe ratio, distinguishes detrimental volatility from overall volatility by focusing on the asset's standard deviation of negative portfolio returns, known as downside deviation, rather than the total standard deviation of portfolio returns.
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.
Advantages and Disadvantages of the Sharpe Ratio
The Sharpe Ratio assesses an investment's risk-adjusted return by comparing its performance to a risk-free asset. A higher ratio signifies better risk-adjusted returns. Its advantages include straightforward calculation and interpretation, insights into risk-return tradeoffs, and facilitating comparisons across investments with varying risk levels. However, limitations include disregarding nonlinear investment behaviors and excluding considerations like taxes and transaction expenses.
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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