For individuals navigating the complex world of investments, identifying the most suitable option can be a daunting task. Fortunately, tools like the Sortino ratio offer investors valuable insights into how an investment performs, particularly when evaluating potential risks.
What is the Sortino Ratio?
The Sortino ratio serves as a valuable metric for assessing an investment’s performance concerning its downward movement, disregarding the overall volatility in its value. Unlike traditional metrics, this ratio provides a more nuanced understanding of the risks associated with specific investments, such as stocks or funds, by gauging how well they perform while factoring in the potential for losses.
Why is it useful?
For everyday investors, emphasizing the risks tied to an investment is crucial. The Sortino ratio focuses specifically on the negative changes in an investment’s value, offering a clearer perspective on its performance after accounting for potential risks.
How to calculate the Sortino Ratio?
Sortino Ratio = Actual or expected portfolio return – Risk-free rate/Standard deviation of downside or Downside deviation
Understanding Sortino with an example
Let us say we have two mutual funds – ABC and XYZ. ABC has an annual return of 20% with a downside deviation of 10%, while XYZ has a 15% return with a downside deviation of 5%. If the risk-free rate is 6 per cent, we can calculate their Sortino ratios.
ABC Mutual Fund Sortino =20% – 6%/10% =1.4
XYZ Mutual Fund Sortino =15% – 6%/5% =1.8
What does it mean?
A higher Sortino ratio signifies better performance. Despite XYZ offering a slightly lower annual return than ABC, it demonstrates more efficient performance when factoring in the associated risks. Thus, based on this ratio, XYZ could be considered the superior investment choice.
Investors may opt to use either the risk-free rate or their expected return in calculations, but consistency is key for accurate results.
Understanding the Sortino ratio empowers investors to make more informed decisions about their investments, enabling them to strike a balance between potential returns and associated risks.
