Definition of 'Sortino Ratio'
A modification of the Sharpe ratio that differentiates harmful volatility from general volatility by taking into account the standard deviation of negative asset returns, called downside deviation. The Sortino ratio subtracts the risk-free rate of return from the portfolio’s return, and then divides that by the downside deviation. A large Sortino ratio indicates there is a low probability of a large loss. It is calculated as follows:
Investopedia explains 'Sortino Ratio'
The formula does not penalize a portfolio manager for volatility, and instead focuses on whether returns are negative or below a certain threshold. The mean in the Sortino ratio formula represents the returns a portfolio manager is able to get above the return that an investor expects.
Determining whether to use the Sharpe ratio or Sortino ratio depends on whether the investor wants to focus on standard deviation or downside deviation. Sharpe ratios are better at analyzing portfolios that have low volatility because the Sortino ratio won’t have enough data points to calculate downside deviation. This makes the Sortino ratio better when analyzing highly volatile portfolios.
While using the risk free rate of return is common, investors can also use expected return in calculations. In order to keep the formulas accurate, however, the investor should be consistent in what return type is used.
The ratio was named after Frank A. Sortino.
For an in-depth knowledge of this ratio, read Mitigating Downside With The Sortino Ratio and 5 Ways To Rate Your Portfolio Manager.