Sortino ratio measures excess return per unit of downside risk. It is calculated by dividing the difference between portfolio return and risk-free rate by the standard deviation of negative returns. A higher Sortino ratio is better.
Rational investors are inherently risk-averse and they take risk only if it is compensated by additional return. Sharpe ratio is a common measure of risk-return trade-off. It compares excess return with total standard deviation of the portfolio’s investment returns, a measure of both the deviations above the mean return and those below the mean return. But upside deviations are good for an investor, so the real risk which investors should worry about is the risk of returns falling below the mean. Sortino ratio defines risk as the risk of downside variation only and provides a better picture of risk-adjusted performance than the Sharpe ratio.
The following formula shows calculation of Sortino ratio:
|=||Portfolio Return − Risk Free Rate|
|Portfolio Downside Standard Deviation|
The numerator of Sortino ratio equals Jensen's alpha. Portfolio return equals the weighted-average return of the whole portfolio of investments. It is calculated as the sum of product of investment weights and individual return. Risk-free rate equals the yield on long-term government bonds.
Downside standard deviation is calculated as follows:
STEP 1: Identify the reference point below which the return is considered bad, let us call it minimum acceptable return (MVR), it might be the mean return, the risk-free rate or 0.
STEP 2: Find deviation of each return value from the minimum acceptable return, if the value is above MVR, ignore it and if the value is below MVR, square it.
STEP 3: Sum up all the squared values in Step 2.
STEP 4: Divide values obtained in Step 3 by n, i.e. the total number of observations
STEP 5: Take square root of the value in Step 4.
Let us calculate Sortino ratio for Apple and Google from 1 January 2017 to 31 December 2017.
The monthly return data is as follows:
Let us say the risk-free rate is 5% and the monthly minimum acceptable return is 2%.
The following table shows calculation of squared deviations where the investment return is lower than MAR:
The monthly squared deviations lower than MAR sum up to 0.66% and total observations are 12, so the monthly downside deviation of Google is 2.45% (i.e. square root of (0.66%/11) which is annualized by multiplying it with 12(1/2):
Annualized standard deviation = 2.45% × 121/2 = 8.49%
Similarly, we work out that annualized downside deviation for Apple is 12.39%.
Return over the period for Google and Apple works out to 46.83% and 41.95% respectively.
Now, we calculate Sortino ratios:
|Sortino Ratio (Google) =||46.8% − 5%||= 4.93|
|Sortino Ratio (Apple) =||41.95% − 5%||= 2.98|
Even there is not significant difference between returns on both stock, there risk-return tradeoff is quite different. Google has way better return per unit of downside risk.