When you invest money through any scheme, it is always better if you know about the scheme’s past performance. This helps to know if the scheme fits your financial requirements and goals. To know the scheme’s fundamentals and past performances in the market, you can use certain financial ratios like the Sortino ratio.
This article focuses on the basics of the Sortino ratio and how you can use it to find an investment scheme that suits you.
What is Sortino Ratio?
The Sortino ratio is a financial ratio that helps to measure the performance of an investment scheme with respect to risk-adjusted returns of the scheme. When you invest in a particular scheme, it is not only important to check the scheme based on its rate of return, but it is also important to consider the possible risks associated with the scheme.
The Sortino ratio measures the scheme’s performance by considering the possible risks associated with the scheme.
The risks that investors commonly face after investing in a scheme are broadly classified as upside risks and downside risks. While upside risks are a potential financial gain, downside risks are a potential financial loss that you face through your investment scheme.
While there are other ratios like the Sharpe ratio that acknowledge both upside and downside risks by treating them as equals, the Sortino ratio acknowledges their differences and represents a realistic idea about downside risks associated with the scheme. The Sortino ratio is considered to be a better version of the Sharpe ratio, which only deals with returns that are likely to face downside risks.
Hence, by using the Sortino ratio you get an accurate measure of the rate of return in case of any downside risks, which helps you to understand the scheme’s performance during its negative deviation. The Sortino ratio is more suitable for retail investors as they are more worried about the downside risks associated with the investment scheme.
Formula & calculation of Sortino Ratio
The Sortino ratio is found when you divide the difference between the rate of returns and risk free returns by the standard deviation of the negative returns. A high Sortino ratio is preferred as it indicates that the investment gives higher return with respect to each unit of downward risk.
The formula used to calculate the Sortino ratio is-
Sortino Ratio = (Average Realised Return − Expected Rate of Return)
Downside Risk Deviation
For example : Let’s consider there are two investment schemes to choose from— Scheme A and Scheme B. Using the above formula you can calculate the sortino ratio of both these schemes to figure out which one is better.
| SCHEMES | Average realised return | Expected rate of return | Downside risk deviation |
| Scheme A | 12% | 8% | 6% |
| Scheme B | 16% | 8% | 14% |
Putting the above values into the Sortino ratio formula you get-
Sortino Ratio (Scheme A) = (12 − 8) / 6 = 0.66
Sortino Ratio (Scheme B) = (16 − 8) / 14 = 0.57
As we have discussed above, a higher sortino ratio is better. So in this example Scheme A will give you better returns than Scheme B. However, none of these schemes can be considered to be ideal as by the rule of thumb the sortino ratio of 2 and above is considered to be ideal.
Things to consider while using the Sortino Ratio
While Sortino ratio is a great financial ratio to measure your scheme’s returns considering the downside risks associated with that particular scheme, there are a few things you need to consider when using the Sortino ratio.
- The first factor to consider is the time of investments to consider. It is advised that you consider the past investments of the scheme you choose through the past few years. This will give you a clear idea of the scheme through both positive as well as negative stocks.
- The second factor to consider is the liquidity of the scheme. If you use the sortino ratio of an illiquid scheme, the risk free returns may seem favourable but in reality it is only because of the scheme’s illiquidity.
How to use the Sortino Ratio to choose suitable mutual funds to invest in?
Mutual funds are a preferred investment scheme by a lot of investors, mainly due to higher returns received through them. The Sortino ratio helps you to choose the right mutual fund scheme to invest in by calculating the returns considering the downside risks.
As we have already discussed the formula to calculate the Sortino ratio, you simply have to use that formula to measure the performance of a mutual fund scheme to see if it is the scheme that suits your financial goals.
Example of How to Use the Sortino Ratio
Here is an example of how to use the Sortino ratio. Suppose there are two investments, A and B. Investment A has an average return of 10% and a risk-free rate of 6%. Investment B has an average return of 15% and a risk-free rate of 6%. The standard deviation of negative returns for investment A is 4%, and the standard deviation of negative returns for investment B is 12%. The Sortino ratio calculation for A is: (10-6)/4 = 1. The Sortino ratio calculation for B is: (15-6)/12 = 0.75. In this case, investment A has a higher Sortino ratio than investment B, which means that it is earning more return per unit of the bad risk that it takes on.
Conclusion
Also as discussed above, the higher the Sortino ratio the better. So, a mutual fund scheme with higher sortino ratio is the one you should choose but make sure you also take into effect other factors like the past performance of the fund, expertise of the fund manager, your risk profile, investment horizon, etc when you are choosing a mutual fund.
FAQs on Sortino Ratio
- What is the difference between Sortino ratio and Sharpe ratio?
While both sortino and sharpe ratios are used to calculate risk adjusted returns, the main difference is that the sharpe ratio considers both upside risks and downside risks as equal when calculating the risk adjusted returns while sortino ratio acknowledges the difference between the upside risks and downside risks.
- When can you use the Sortino Ratio?
The sortino ratio focuses on the returns given by an investment scheme when it’s likely to have downside risks. So the sortino ratio is helpful when you are more worried about the downside risks associated with the investment scheme.
- What is considered to be an ideal sortino ratio?
As a rule of thumb, the sortino ratio of 2 or above is considered to be ideal.
- What is a good sortino ratio while choosing a mutual fund to invest in?
The higher the sortino ratio, the better. So, while choosing a mutual fund scheme to invest in, you should always go for the scheme with higher sortino ratio.
- What is the formula for calculating the sortino ratio?
The formula to calculate the sortino ratio is-
Sortino ratio = (Average Realised Return − Expected Rate of Return) / Downside Risk Deviation
