Sortino Ratio

The Sortino ratio is a modification of the Sharpe ratio that penalizes only negative volatility, i.e., returns below a target return (often the risk-free rate). Unlike the Sharpe ratio, which considers all volatility (positive or negative) as risk, the Sortino ratio argues that only the risk of loss (downside volatility) is truly relevant to investors. It is calculated by dividing the excess return (portfolio return minus the target return) by the standard deviation of negative returns. A high Sortino ratio indicates better risk-adjusted performance, as it suggests that the portfolio generates significant returns relative to the downside volatility it experiences. It is particularly useful for comparing investments with asymmetric risk profiles, where positive returns are more frequent or larger than negative returns. By focusing on downside volatility, the Sortino ratio offers a more accurate measure of the risk relevant to risk-averse investors.