Sharpe Ratio vs Sortino Ratio: Key Differences Every Investor Should Know

J.B. Maverick brings over 17 years of expertise as an active trader, commodity futures broker, and stock market analyst, alongside more than a decade of experience in finance writing and book editing.

Understanding the Core Differences Between Sharpe and Sortino Ratios

Both the Sharpe and Sortino ratios serve as valuable tools to evaluate investment returns by adjusting for risk. The Sharpe ratio compares an equity investment's performance against a risk-free benchmark, factoring in the total risk involved. In contrast, the Sortino ratio refines this approach by focusing solely on downside risk, ignoring the volatility from positive returns. Investors aiming for a comprehensive assessment should prioritize risk-adjusted returns over simple returns when selecting investments.

Key Insights:

• Sharpe and Sortino ratios both measure risk-adjusted investment returns.
• The Sharpe ratio accounts for total volatility relative to a risk-free rate.
• The Sortino ratio isolates downside risk, excluding positive volatility.
• Sharpe is generally preferred for low-volatility portfolios; Sortino is favored for portfolios with higher volatility.

Diving Deeper: Sharpe Ratio Explained

The Sharpe ratio, often called the reward-to-variability ratio, is a widely used metric in portfolio management. It calculates the difference between an investment's return and a risk-free rate (such as U.S. Treasury bills), then divides that by the investment's standard deviation, representing total risk. A negative Sharpe ratio suggests that a risk-free investment would outperform the portfolio on a risk-adjusted basis. Ratios of one or above typically indicate a favorable risk-return balance.

Analyst Preference

Financial experts commonly apply the Sharpe ratio to evaluate portfolios with low volatility, while reserving the Sortino ratio for those with more pronounced fluctuations.

Understanding the Sortino Ratio

The Sortino ratio modifies the Sharpe approach by focusing exclusively on downside deviation, disregarding total volatility. This distinction makes it particularly useful for retail investors concerned primarily with potential losses rather than overall variability. By excluding upside volatility from risk calculations, the Sortino ratio offers a more targeted view of negative performance risks.

Calculating the Sharpe Ratio

To compute the Sharpe ratio, subtract the risk-free rate from the asset's return to find the excess return, then divide this figure by the standard deviation of the asset's returns, which quantifies total risk.

Calculating the Sortino Ratio

The Sortino ratio is calculated similarly but uses the standard deviation of negative returns (downside deviation) instead of total standard deviation, focusing the risk measure solely on harmful volatility.

Measuring Volatility

Volatility measurement is essential in these calculations. Standard deviation is the most common method, representing the spread of an asset's returns. Beta is another metric that compares an asset's volatility to a broader market benchmark like the S&P 500, offering insights into relative risk.

Conclusion

Both the Sharpe and Sortino ratios are indispensable for evaluating investment returns with risk considerations. While their formulas are similar, the Sortino ratio's focus on downside risk provides a nuanced perspective, especially valuable for investors sensitive to losses.

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