The Sharpe ratio and the Sortino ratio are both risk-adjusted evaluations of return on investment. The Sortino ratio is a variation of the Sharpe ratio that only factors in downside risk.
A Sharpe ratio 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 on an individual stock, then dividing that number by the standard deviation of the stock or portfolio. 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. 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 1 or higher is commonly considered to be a good risk-adjusted return rate.
The Sortino ratio variation of the Sharpe 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 it, 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.