The Difference Between the Sharpe Ratio and the Sortino Ratio

What Is the Difference Between the Sharpe Ratio and the Sortino Ratio?

The Sharpe ratio and the Sortino ratio are both risk-adjusted evaluations of return on investment. The Sharpe ratio indicates how well an equity investment is performing compared to a risk-free investment, taking into consideration the additional risk level involved with holding the equity investment. The Sortino ratio is a variation of the Sharpe ratio that only factors in downside risk. Before selecting an investment vehicle, investors should seek the risk-adjusted return and not just the simple return.

Understanding the Sharpe Ratio and the Sortino Ratio

The performance of an investment or portfolio should not be judged on total returns alone. Because higher risk investments typically yield higher returns, the risk-adjusted return is a better way to assess a portfolio. The simple return ignores the risk taken by the fund to generate returns. Financial ratios are a tool for assessing the risk–adjusted return of an investment portfolio and its performance.

Calculating the Sharpe Ratio

The Sharpe ratio is also called the reward-to-variability ratio and is the most common portfolio management metric. It is calculated by subtracting the rate of return on an investment considered risk-free, such as a U.S. Treasury bill, from the expected or actual return on an equity investment portfolio or an individual stock, then dividing that number by the standard deviation of the stock or portfolio. A negative Sharpe ratio indicates that the investor would have a better risk-adjusted rate of return using a risk-free investment. A Sharpe ratio of one or higher is commonly considered a good risk-adjusted return rate.

Calculating the Sortino Ratio

The Sortino ratio variation of the Sharpe ratio measures the performance of the investment relative to the downward deviation. Unlike Sharpe, the Sortino ratio does not consider the total volatility of the investment. This ratio can be effectively applied to retail investments because there is more concern for the downside risk. The ratio only factors in the downside, or negative volatility, rather than the total volatility used in calculating the Sharpe ratio. The theory behind the Sortino variation is that upside volatility is a plus for the investment and, therefore, should not be included in the risk calculation. Therefore, the Sortino ratio takes upside volatility out of the equation and uses only the downside standard deviation in its calculation instead of the total standard deviation that is used in calculating the Sharpe ratio.

Analysts commonly prefer to use the Sharpe ratio to evaluate low-volatility investment portfolios and the Sortino variation to evaluate high-volatility portfolios.