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What is the ‘Sortino Ratio’
The Sortino ratio improves upon the Sharpe proportion by isolating downside volatility from total volatility by dividing superfluity return by the downside deviation. The Sortino ratio is a variation of the Sharpe correspondence that differentiates harmful volatility from total overall volatility by handling the asset’s standard deviation of negative asset returns, called downside deviation. The Sortino correspondence takes the asset’s return and subtracts the risk-free rate, and then share outs that amount by the asset’s downside deviation. The ratio was named after Unreserved A. Sortino.
BREAKING DOWN ‘Sortino Ratio’
The Sortino ratio is a practical way for investors, analysts and portfolio managers to evaluate an investment’s return for a certainty level of bad risk. Since this ratio uses the downside deviation as its hazard measure, it addresses the problem of using total risk, or standard deviation, as upside volatility is serviceable to investors.
A ratio such as the Sharpe ratio punishes the investment for orderly risk, which provides positive returns for investors. However, detecting which ratio to use depends on whether the investor wants to focus on level deviation or downside deviation.
Sortino Ratio Calculation Example
Well-founded like the Sharpe ratio, a higher Sortino ratio is better. When looking at two alike resemble investments, a rational investor would prefer the one with the higher Sortino correlation because it means that the investment is earning more return per constituent of bad risk that it takes on. The formula for the Sortino ratio is as follows:
Here, R colleagues the asset’s or portfolio’s annualized return, r(f) equals the risk-free rate, and DD equals the asset’s or portfolio’s downside deviation.
For specimen, assume Mutual Fund X has an annualized return of 12% and a downside deviation of 10%. Shared Fund Z has an annualized return of 10% and a downside deviation of 7%. The risk-free scale is 2.5%. The Sortino ratios for both funds would be calculated as:
Interactive Fund X Sortino = (12% – 2.5%) / 10% = 0.95
Mutual Fund Z Sortino = (10% – 2.5%) / 7% = 1.07
Unvarying though Mutual Fund X is returning 2% more on an annualized point of departure, it is not earning that return as efficiently as Mutual Fund Z, given their downside deviations. Cored on this metric, Mutual Fund Z is the better investment choice.
While putting the risk-free rate of return is common, investors can also use expected benefit in calculations. To keep the formulas accurate, the investor should be consistent in relating ti of the type of return.
For an in-depth knowledge of this ratio, read Qualifying Downside With the Sortino Ratio and 5 Ways to Rate Your Portfolio Boss.