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While many would say that you should always look at the bright side of life, the Sortino ratio shows us how focusing on the negative can help us make positive changes.
All reviews, research, news and assessments of any kind on The Tokenist are compiled using a strict editorial review process by our editorial team. Neither our writers nor our editors receive direct compensation of any kind to publish information on tokenist.com. Our company, Tokenist Media LLC, is community supported and may receive a small commission when you purchase products or services through links on our website. Click here for a full list of our partners and an in-depth explanation on how we get paid.
What are your strengths and weaknesses?
Or, let’s put it in more financial terms: what are your assets and liabilities?
This isn’t always as easy to figure out as it might appear. Let’s assume you have two houses—wonderful, you are a serious landlord—and the houses are very similar. However, they aren’t quite the same. The first is a low coastal plain near the sea, the second is in a very unassuming town somewhere inland.
It might appear like the one by the sea is your strength, more of an asset. But let’s take this analysis a bit further. The coastal house is in the path of hurricanes and, to make matters worse, the dykes guarding its plain are almost overflowing, it only takes one more Polar glacier to melt and you’d have a major flood. 📊
Is the house by the sea still an asset? We think it is starting to look more and more like a liability. On the other hand, the house inland is (for the moment) somewhat neutral. But, it is relatively close to a famous ski resort and the city council is debating constructing a gondola.
If this happens, the ski slopes would be less than half an hour away and that unassuming property would suddenly become a real asset.
When it comes to the stock market, the Sortino ratio is there to tell you just how much in repairs you’d have to pay for the sea house and if it’s worth keeping it considering the rent you are getting for it.
It helps you see just how much bad risk there is to any asset you are holding or looking to buy and if it outweighs any potential benefits. This knowledge should factor in any financial decisions you are looking to make, especially in times of increased uncertainty like when the inflation crisis is likely to make a real dent even in generally considered-to-be-safe portfolios like the popular 60/40. 💸
So, let’s take a good look at the Sortino ratio—what it’s good for, how to calculate it, how to use it, and what are some of its shortcomings.
The Sortino ratio is a variant—and some would say an improvement—of the Sharpe ratio. It was developed by and named after Frank A. Sortino, and in many ways, it is the same as the Sharpe ratio which evaluates the risk-adjusted return on investment.
The Sortino ratio makes one key change—where the Sharpe ratio takes into account both positive and negative deviation, the Sortino only looks at downward deviation. The reasoning behind this choice is that upward deviations are generally beneficial to the investor and shouldn’t be included in a measurement of which stocks to avoid due to volatility.
Most analysts tend to prefer the Sharpe ratio for more stable investments and the Sortino ratio for the more volatile ones—and when Morgan Stanley analysts say that the global markets are seemingly calm but tumultuous underneath, it might be Sortino’s time to shine amid the uncertainty.
The calculation for the Sortino ratio is fairly similar to its parent Sharpe ratio and thankfully a bit simpler than its sister Treynor ratio. It has three main elements: the actual return of the measured asset, risk-free return rate, and downward deviation—which is also known as the standard deviation of the downside.
The actual return rate is rather self-explanatory but the risk-free return can be a bit finicky. This is because there is neither a truly risk-free investment nor a universally accepted benchmark. That being said, bonds tend to be the industry standard—a practice with merit as their surge along as a hedge against inflation increases of late 2021 coming together with Bitcoin and gold price rises.
Still, this part of the equation remains somewhat arbitrary and is left to the investor’s discretion to a large extent.
Downward deviation has its own calculation which we’ll be looking at more closely a bit down the line. So, without further ado, the formula for the Sortino ratio is:
Here’s what these symbols mean:
< R > = Expected Returns
R_{f} = Risk-Free Rate of Return
σ_{d }= Standard Deviation of the Downside
So, for simplicity’s sake let’s say that there is an ETF called Example ETF (Exmp) with an expected return rate of 15% and a downward deviation of 2.5%. We’ll also round the risk-free return rate to a neat 3%. This would mean that the Sortino ratio of our Exmp is:
Sortino(Exmp)=(15-2.5)/3=12.5/3
Sortino(Exmp)=4.17
The standard deviation of the downside is somewhat more complicated to calculate than the actual Sortino ratio.
Now that is a scary formula so let’s break it down a bit. First of all, the so-called minimum acceptable return is a key concept when determining downward deviation. However, there is a caveat—just like the risk-free return, it is somewhat arbitrary.
Furthermore, to add to this, a risk-free rate is often chosen as this parameter. This is not necessarily the case, though, as you (the investor) have the final say in what the minimum return you are willing to accept is.
This is the r* in the equation while the rt is the actual return. The next thing you’d want to do is subtract the r* from the rt for every period you are measuring and then square all the negative results. This means that if you get 3 for period A and -1 for period B you only take period B into account.
Next, you’d add together all these squared results and divide the number you get by the total number of periods measured. Finally, you’d take the square root of the total to get the downward deviation. So, let’s take a look at an example using actual numbers—made-up-for-the example numbers, but numbers nonetheless.
So, let’s say that we are looking at 5 years and that our chosen minimum acceptable return is once again 3%.
Year | Return | Minimum | Result of division |
---|---|---|---|
1 | 9 | 3 | 6 |
2 | 2 | 3 | -1 |
3 | -8 | 3 | -11 |
4 | 4 | 3 | 1 |
5 | 10 | 3 | 7 |
This means that for our squaring and summing we’d only take years 2 and 3 into account. So we’d get 1 and 121 and sum them up to get 122. Then, we’d divide 122 by the total number of periods we’ve measured—5.
122/5=24.4
Finally, we’d take the square root of 24.4 making our standard deviation of the downside 4.94.
On the flip side, while this math is very useful to know, the good news is that information like the Sortino ratio can be more easily and automatically calculated by using some of the top stock analysis software available.
The Sortino ratio is similar to its parent, the Sharpe ratio, in that the number you are aiming for is 2 or above. However, since your results can vary widely depending on the exact parameters you choose it is still best utilized as a comparison tool.
This means that between two investments that offer the same returns the one with the higher Sortino ratio should be chosen—whether this means that you are looking to buy or ditch something.
There are several ways you could go about using the Sortino ratio. The first and most obvious would be when looking to add a security to your portfolio. If you are in two—or multiple—minds between what to purchase, you’d just see whichever option has the highest ratio.
Alternatively, you could either decide on the minimum Sortino ratio you’d accept in an investment or even make the calculation for your portfolio before and after the purchase. The idea would be that if your portfolio’s ratio would fall after adding a security, you’d skip on it and vice-versa.
The same could go if you are unsure if holding a certain asset is making your portfolio worse. If its Sortino ratio falls after selling an asset it indicates that the asset is a keeper after all.
The main advantage of the Sortino ratio is its intended purpose—it is a great tool for investors, analysts, and managers to tell just how much they can make by accepting additional bad risk.
On the other hand, this ratio has a big limitation shared with many other tools used in both technical and fundamental analysis—it is best used as a part of a team of instruments as alone, it gives a relatively loose guideline.
Another weakness of the Sortino ratio comes down to the way it is calculated. On one hand, there is the entire issue of using risk-free returns which is both an untenable goal—especially if we were to try and find a number that truly fits the definition—and leaves room for meddling with the parameters.
The other limitation in the formula is that it uses downward deviation. The minimum acceptable return is the culprit here as it is pretty much fully left to the user’s discretion—and it can be argued that it would defeat the point if not left for the user to decide.
On the one hand, the problematic concept of treasury bonds as a risk-free investment vehicle—mind you, we aren’t saying that buying bonds is bad in every case, nor that they aren’t low-risk, just that no-risk is a loaded concept—on the other the arbitrariness of it all.
What happens if your minimum acceptable return is something like 20%, or maybe even higher—which might not be as insane as it sounds as some specialty funds promise high risks but hundreds of percent in returns. It is rather obvious how different the end Sortino ratio would be if you chose a bond rate of around 2.5% as the minimum as opposed to that 20%, or any number between.
Furthermore, the Sortino ratio can yield unusable results—unless you want to implode the universe or something. What we mean by this is that if you are trying to find the downward deviation of a generally well-performing fund with the minimum acceptable return being 2-3% you might end up with no negative numbers which would put you in a spot where you’d have to divide by 0.
Over the years, the Sortino ratio has come under criticism from various experts including Frank Sortino himself. He says that when he developed the formula in the 80s, he believed that it was the best tool for figuring out risk-adjusted gains but that data contradicting this notion started piling up during the 90s.
His data found that not only is the Sortino ratio not that good at predicting—funds with a good ratio continued their performance into the next year in 22% of the cases—but that the Sharpe ratio was a bit better being right in 23% of the cases. This is a rather lackluster performance especially when we consider the Sortino ratio is intended as an improvement over the Sharpe ratio.
Sortino has since developed a new method called Desired target rate-alpha (DTR) which he outlines in his book The Sortino Framework for Constructing Portfolio.
💡 Not sure about alpha yet? Learn about alpha in stocks.
William Sharpe did comment on this criticism saying that his index was meant as a way to boil down some complex data into a single number both acknowledging and rebuking the detractors. Ultimately, this is true of the Sortino ratio as well and truly shines an entirely new light on one of the few true truisms—use as many tools as you can and trust none of them utterly. Each of them can only tell you so much.
It can be argued that at their core the Sortino and the Sharpe ratio are the same. They both boil down a very complex set of parameters and consideration to a single number with the bigger the better mentality to it. As we’ve thoroughly established this is both good and insufficient.
On the other hand, they both have their merits. The fact that the Sortino ratio only takes the downward deviation makes it far better at telling you if the risks involved aren’t worth it. Looking at our houses from the first segment, the Sharpe ratio would consider the possibility of a gondola to the ski resort to be just as bad as hurricanes and floods. The Sortino ratio would only look at and warn you of the latter.
For a more real-world example, since penny stocks tend to be a very uncertain way of investing, the Sharpe ratio probably wouldn’t be able to give you a lot of useful data—they are nothing if not volatile.
But, the Sortino ratio could help you when trying to find penny stocks through a broker such as Robinhood—the focus on bad risk could help you along the way of finding true gems and separating them from real weeds.
However, the fact that the Sharpe ratio uses standard deviation can help you maintain the stability of your portfolio. The fact that unexpected major upturns are generally considered a good thing means there are times when you might prefer predictability depending on the investment strategy you’ve concocted for yourself.
The Sortino ratio is a bit of a confusing bag. On one hand, it is often hailed and lauded by analysts to make your investing smarter. On the other, even its own creator believes it simply isn’t that good. However, Sun Tzu taught us that we must know both ourselves and the enemy to win and as long as we are aware of the limitation of the tools we are using, the Sortino ratio can help us come on top.
While we have derided the Sortino—and the Sharpe—ratio for its use of bonds as risk-free investments, their usefulness is, after all, not entirely without merit. Bonds hold a special place for a reason, and underestimating their safety has been the downfall of many, as was recently showcased by the resurfacing of an old and famously wrong book about the Dow—one of its major flaws was assuming stocks were as low-risk as bonds.
The Sortino ratio is a way to measure a portfolio return compared to harmful volatility. It takes into account downside deviation and tells you just how furth your investments are compared to risk-free alternatives when you factor in the extra bad risk you are taking.
Generally speaking, a Sortino ratio of 2 or higher is considered ideal. However, since you won’t always find investment alternatives with this ratio, and the numbers can change depending on the parameters you’ve chosen, it can also be used as a comparison tool. When looking at two or more investments, the one with the highest ratio is considered the best.
The Sharpe ratio factors in standard deviation while the Sortino ratio only looks at downside deviation. This means that the Sharpe ratio looks at all volatility and punishes a portfolio for unexpected gains just as much as unanticipated losses. The Sortino ratio lowers the score only for going below expected average returns.
Generally speaking, yes. The Sortino ratio of 2, or more is considered ideal, but when looking at multiple investment possibilities, the one with the highest ratios is indicated to be the best one.
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All reviews, research, news and assessments of any kind on The Tokenist are compiled using a strict editorial review process by our editorial team. Neither our writers nor our editors receive direct compensation of any kind to publish information on tokenist.com. Our company, Tokenist Media LLC, is community supported and may receive a small commission when you purchase products or services through links on our website. Click here for a full list of our partners and an in-depth explanation on how we get paid.