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Return and risks are two main considerations in investment. In this regard, the Sortino Ratio is an important tool named after Frank A. Sortino. It is used to measure and evaluate the risk-related return of an investment. It is particularly useful in downside risk. To effectively handle mutual fund investments, it is important to understand the essence of Sortino Ratios.
This article inspects the definition and calculative method of a Sortino Ratio.
What is the Sortino Ratio?
Unfortunately, many performance indicators don’t adjust the investment risk, which we can observe in periods of moving markets. All they do is to take their view of the time value of money. To sum up here, the Sortino Ratio truly is the prevailing Ratio. Through the examination of interest rate differences, this indicator gives investors more chances to make the most well-judged investment decisions.
The Sortino Ratio is exceptional because it can present the difference between the risks headed upward and the risks that are headed downwards. In a grosser sense, it contrasts the Sharpe Ratio by eliminating the cost of any unpleasant risk, leading to an authentic and fair evaluation.
How to Calculate the Sortino Ratio
To effectively implement the Sortino Ratio, you must know how to calculate it.
Sortino Ratio Formula = (Average Realised Return – Expected Rate of Return) / Downside Risk Deviation
The average realised return is the weighted mean return of all the investments in a person’s portfolio. On the other hand, the return on long-term government securities is known as the risk-free or required return rate.
So basically, S = (R – T) / DR
Where S is the Sortino Ratio, R is the average realised return, T is the required rate of return, and DR is the target downside deviation.
Consider annual rates of 4%, 10%, 15%, 20%, -7%, -6%, -4%, 8%, 25%, and 15%.
Then the average will be (4%, 10%, 15%, 20%, -7%, -6%, -4%, 8%, 25%, and 15%)/ 10 = 8%
Assume the target or required rate of return is 4%. The additional return will be (8% – 4%)= 4%. This is the numerator in the equation.
Try to evaluate the standard deviation of downward risks. Positive returns will not be considered since their deviations are zero.
Thus, square the downside deviation and calculate the average.
(-6%)² = 0.0036
(-7%)² = 0.0049
(-4%)² = 0.0016
Average = (0.0036 + 0.0049 + 0.0016) / 10 = 0.00101
Lastly, calculate the standard deviation by getting the square root of
√0.000101 = 0.0318
R = 8% and T = 4% DR = 0.0318
S = 0.04/0.0318 = 1.26
A Sortino Ratio of 2 and above is deemed ideal. Thus, this investment’s 1.26 rate is almost good but not perfect.
How can the Sortino Ratio be used?
A risk-adjustment statistic called the Sortino Ratio calculates the additional return for every unit of downside risk. It is calculated by determining the difference between the risk-free rate and the average return on an investment. Next, the outcome is divided by the negative return standard deviation.
When should the Sortino Ratio be used?
A Sortino Ratio in mutual fund is a better criterion than the Sharpe Ratio because it considers the downside of risks. It’s exactly the proper analysis because investors’ priority here is to ensure there are no cases of things going wrong, which is something they should worry about. Risk factors don’t imply an alarming state of things; instead, these are opening the gate to exploring the issue and finding possible solutions.
In contrast, the Sharpe Ratio applies the same methodology to both upside and downside risks. It implies that investments that yield profits are also penalised, which is unfair. Consequently, the Sortino Ratio should be employed when evaluating the performance of assets with significant volatility, like shares. By contrast, the Sharpe Ratio is better suited for examining assets with minimal fluctuations, such as bonds.
What is the Sharpe Ratio?
Although the Sortino Ratio is an excellent tool for analysing assets, there are a few considerations you should make. The timeline is one. Considering investments made over several years, or at least during an entire business cycle, would be beneficial.
You may account for both positive and negative stock returns by doing this. It wouldn’t be an accurate representation of an investment if you were to record the profitable stock returns simply. The assets’ liquidity is the second consideration. Although a portfolio may appear less hazardous, this could result from holding illiquid underlying assets.
How to calculate the Sharpe Ratio?
The Sharpe Ratio evaluates an investment’s risk and return. It’s a mathematical representation of the realisation that excess profits over time could indicate increased risk and volatility rather than skill in investing.
The difference over time between realised or projected returns and a benchmark—such as the risk-free rate of return or the performance of a specific investment category—is the numerator of the Sharpe Ratio. The standard deviation of returns over the same period
, a gauge of risk and volatility, serves as its denominator.
Sortino Ratio vs. Sharpe Ratio
The whole market volatility is considered when calculating returns using the Sharpe Ratio. It also takes into account both positive and negative risks. On the other hand, the Sortino Ratio only considers adverse risks when assessing additional returns. Investors prefer Sortino Ratios since downside risk is their main worry. Nonetheless, the choice will depend on the specific investment’s goals, ease, and objectives.
The Sortino Ratio is considered to determine downside risk because it differs from beta, which is the main difference. The Sharpe Ratio differs from that since it is not only the upside risk it focuses on but also the downside risk. You can use the Sharpe or the Sortino Ratio per the investor’s investment agenda and preference. According to investors, who are more attracted to both upside and downside risks, focusing on the Sharpe criterion might be the right decision. However, investors who are more sceptical about downside risk but also want to limit it may prefer the Sortino Ratio rather than the Sharpe Ratio.
Conclusion
Having this particular one aside, they are not much different. The Sharpe ratio, which adjusts for (both positive and negative) investment outcomes regardless of risk, is a standard measure of return for “risk-adjusted performance”. Furthermore, the Sortino Ratio is different because it only considers harmful risks in evaluating the risk-adjusted return. On the other hand, the Sortino ratio disregards upward risks, which cannot be the basis for worried investors. Thus, it is used to better measure a portfolio’s risk-adjusted returns.
FAQs
To calculate the Sharpe ratio, investors first subtract the risk-free rate from the portfolio’s rate of return, often using U.S. Treasury bond yields as a proxy for the risk-free rate of return. Then, they divide the result by the portfolio’s excess return standard deviation.
The main application of the Sortino Ratio is to assess the extra risk for a given risk as an additional return. It is made up by determining the variance between the weighted fund return average and the risk-free rate. As a result of this calculation, the negative returns standard deviation is then used in the denominator to determine the result.
The Sortino ratio is a very effective tool for investors, analysts, or portfolio managers who may consider allowing the bad risk caused by the return to be a given criterion.
The Sharpe ratio is a tool for working out risk-adjusted returns and volatility. Risk assessment or analysis is the last tool, applicable in positive and negative contexts. On the other hand, the Sortino ratio is a tail risk measure because it filters the returns in critical circumstances above a certain level of negative deviation for the volatility. Traders become very much focused on the left side of the display, trying to capture low levels of downside risk, so they prefer Sortino ratios.
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