Often retail investors struggle to find the ‘right’ investment scheme which would match their financial requirement and investing capability. However, by making use of financial ratios like the Sortino ratio, they can evaluate the performance of a scheme in a much better manner.
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Sortino ratio is a statistical tool that helps in measuring the performance of an investment with respect to downward deviation. It does not account for the volatility in investment, but it helps by giving a realistic idea about the downside risks that accompany a stock or a fund. Basically, it helps in measuring risk-adjusted returns of a particular investment scheme.
The main ratio is to focus on the negative deviation of an investment portfolio and its returns and thus offering a better idea about such a portfolio’s performance after potential risks have been adjusted.
How is it Calculated?
The formula for calculating This Ratio is as follows:
It is computed by dividing the difference between the aggregated earnings of an investment portfolio and the risk-free rate of return with the standard deviation of negative earnings. Even though the formula is quite similar Sharpe ratio (measurement tool of risk-return trade-offs), the difference between them is that the Sortino ratio uses only the downside volatility to evaluate a portfolio’s performance, whereas the Sharpe ratio uses both the upside and downside volatility.
Example of Sortino Ratio:
There are two investment portfolio schemes, Scheme A and Scheme B. Scheme A has 20% annualized returns, 8% downward deviation, and 12% rate of fixed deposit risk-free. Scheme B has 30% annualized returns, 24% downward deviation, and 12% rate of fixed deposit risk-free.
Using the above information,
Scheme A’s Sortino ratio = (R) – Rf /SD = (20-12)/8 = 1
Scheme B’s Sortino ratio = (R) – Rf /SD = (30-12)/24 = 1.166
Usually, a higher Sortino ratio is considered to be better. So we understand, Scheme B’s Sortino ratio indicates that it is generating more return per unit of the given risk and in turn has a greater chance of avoiding large losses.
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Significance and Limitations of Sortino Ratio:
It takes into consideration the shortcomings of standard deviation as a measure of potential risks in a return and risk trade-off ratio. We need to acknowledge the specific asset class of investment schemes while evaluating an investment portfolio’s performance more accurately. Since this ratio uses the downside deviation method to measure the risk aspect, the shortcomings of the same influence it significantly.
The Sortino ratio is used while determining the risk-adjusted return on investment. It is a refinement of the Sharpe ratio but only takes into consideration the returns, which have downside risks with them.
Author: Mahek Medh
About the Author: Currently, I am in my second-year bachelor’s program and over the period of time I have realized that I enjoy learning about numbers and money, and I find topics of Finance to very interesting thus this is the domain and space where I wish to etch my long term career.