what the sortino ratio can tell you
the sortino ratio is a useful way for investors analysts and portfolio managers to evaluate an investment s return for a given level of bad risk since this ratio uses only the downside deviation as its risk measure it addresses the problem of using total risk or standard deviation which is important because upside volatility is beneficial to investors and isn t a factor most investors worry about example of how to use the sortino ratiojust like the sharpe ratio a higher sortino ratio result is better when looking at two similar investments a rational investor would prefer the one with the higher sortino ratio because it means that the investment is earning more return per unit of the bad risk that it takes on for example assume mutual fund x has an annualized return of 12 and a downside deviation of 10 mutual fund z has an annualized return of 10 and a downside deviation of 7 the risk free rate is 2 5 the sortino ratios for both funds would be calculated as mutual fund x sortino 1 2 2 5 1 0 0 9 5 begin aligned text mutual fund x sortino frac 12 2 5 10 0 95 end aligned mutual fund x sortino 10 12 2 5 0 95 mutual fund z sortino 1 0 2 5 7 1 0 7 begin aligned text mutual fund z sortino frac 10 2 5 7 1 07 end aligned mutual fund z sortino 7 10 2 5 1 07 even though mutual fund x is returning 2 more on an annualized basis it is not earning that return as efficiently as mutual fund z given their downside deviations based on this metric mutual fund z is the better investment choice while using the risk free rate of return is common investors can also use expected return in calculations to keep the formulas accurate the investor should be consistent in terms of the type of return the difference between the sortino ratio and the sharpe ratiothe sortino ratio improves upon the sharpe ratio by isolating downside or negative volatility from total volatility by dividing excess return by the downside deviation instead of the total standard deviation of a portfolio or asset the sharpe ratio punishes the investment for good risk which provides positive returns for investors however determining which ratio to use depends on whether the investor wants to focus on total or standard deviation or just downside deviation 